Understanding Investing in Leveraged ETFs

How many investors read the prospectus before investing?

I spent too long looking for a stat to answer that question, but I couldn’t find a satisfactory one. My guess is that the answer is not enough. 

As a mutual fund and ETF analyst, one of my jobs was to review the prospectus and annual report for all the funds to ensure there were no errors. Fun times!

While maybe not the most exciting task, it did give me an appreciation for the wealth of information available in a prospectus once you dig in. Yes, you have to cut through some boilerplate language, but other than that, there are some real nuggets stashed in there.

Reviewing fund documents is particularly important when it comes to more complex investment products. I think readers of this blog have a pretty good handle on what to expect from an S&P 500 ETF like SPY or VOO. But what about commodities, currency, or leveraged ETFs (LETFs)? How do they gain their target exposure? Do they require special tax forms like a K-1? What are the key risks? 

These are all important questions to answer before investing. In investment writing and on Fintwit (financial twitter), authors will often caveat things with “do your own research” or its abbreviation “DYOR”. Well, today we will do our own research on LETFs. And yes, we are diving into the prospectus. 

‍Leverage 101: how leverage works

‍Leverage in the traditional financial sense means borrowing money to amplify exposure to an asset. Most people are familiar with the concept of borrowing money to buy a house, so we can use home ownership to demonstrate the impact of leverage on returns. 

Take two people who each have $100k to spend on a home. Homeowner One buys a house for $100K, and Homeowner Two buys a house for $200K with a $100K loan from the bank. After one year, housing prices have gone up 10%, and the two homes are worth $110K and $220K, respectively. As someone trying to buy their first home, I assume this is a reasonable assumption that house prices go up 10% every year.

Now, if each homeowner decides to sell, they will have the following returns:

Homeowner One ($110 - $100K) / $100K = 10%

Homeowner Two ($220 - $100K - $100K) / $100K = 20%

For Homeowner Two, they must repay the bank, so we subtract the $100K loan from the selling price. You can see the impact of leverage in the returns. Both homeowners had an asset that went up 10%, but Homeowner Two amplified her gains by taking out a loan. She turned her $100K into $20 of profit while Homeowner One made $10. 

This simplified example ignores the cost of debt. Homeowner Two would owe interest, and that cost would need to be subtracted from returns, but you get a basic understanding of the mechanics of leverage. 

However, like most things you learn in school, that is not exactly how it works in the investing world. Yes, many institutions use leverage as described above to buy financial assets, but most retail investors interact with LETFs, which provide exposure to a multiple of an index (e.g., S&P 500) by using an array of investment strategies, including swaps, futures contracts, and other derivative instruments. They are, for the most part, rebalanced daily, which leads to a number of nuances that investors should understand before investing. 

The effect of compounding on leveraged ETFs

It’s Compounding, Einstein.

“Compound interest is the eighth wonder of the world. He who understands it, earns it; he who doesn't, pays it”.

The quote is attributed to Einstein, but who can be sure with the internet these days.

LETFs have received some heat from regulators. FINRA and the SEC both published investor alerts to notify investors of the risks associated with leveraged products. Much of the nuance of LETFs, and the potential for misunderstanding, comes from the fact that they are rebalanced daily and how their returns are compounded over time. 

This leads to two issues: 

1. Volatility drag

2. Returns over longer time periods deviate substantially from the target exposure (e.g., 3x the index)

We at Composer think that our users are an intelligent bunch, and moreover, that they are willing to take the time to understand nuanced topics. As the SEC says, “The best form of investor protection is to clearly understand leveraged or inverse ETFs before investing in them”. OK, SEC. Challenge accepted.

From the prospectus of UPRO, a popular S&P 500 3x LETF, emphasis added:

The return of the Fund for periods longer than a single day will be the result of its return for each day compounded over the period. The Fund’s returns for periods longer than a single day will very likely differ in amount, and possibly even direction, from the Fund’s stated multiple (3x) times the return of the Index for the same period. For periods longer than a single day, the Fund will lose money if the Index’s performance is flat, and it is possible that the Fund will lose money even if the level of the Index rises. Longer holding periods, higher Index volatility, and greater leveraged exposure each exacerbate the impact of compounding on an investor’s returns.

Let’s start with the second bolded line and discuss volatility drag. 

Volatility drag causes LETF returns to be eaten by the up-and-down movements of the market. Let’s take a look at a simple example. We buy a 2x LETF at $50 that is tracking an index that is also priced at $50. On the first day of trading, the index falls 5% to 47.50. The 2x LETF returns -10% and falls to $45. On the second day of trading, the index rises back to $50, a gain of ~5.25%. The LETF gains ~10.5% and is now worth $49.73. The index has gone full circle, and investors are sitting back at square one. Investors in the LETF, however, have lost 27 cents. And that is before fees and trading costs, both of which will be higher with a LETF compared to a simple index ETF. 

Here is an illustration of volatility drag from the UPRO prospectus:

UPRO Prospectus

In a year where the S&P 500 returned 60% you’d be pretty surprised if your 3x LETF lost 80%, right? But that’s the impact of volatility drag. Granted, it's an extreme example and would only happen if volatility reached 100%, but it helps illustrate the point. 

Relatedly, when the market moves sideways, i.e, returns around 0% with elevated volatility, the impact on relative returns can be dramatic. The index could be flat for the year and a LETF could return -17%. Yikes. 

So, if you are interested in LETFs, what type of volatility should you expect? Well since inception (Jan 1993), the standard deviation of SPY has been 18.8%. Looking forward, Vanguard estimates that the 10-year median volatility on large-cap equities will be ~16%. Year-to-date in 2022, volatility has been above 20%.

Now let’s take the first bolded sentence:

The Fund’s returns for periods longer than a single day will very likely differ in amount, and possibly even direction, from the Fund’s stated multiple (3x) times the return of the Index for the same period.

If we go back to our simple example above with our 2X LETF, you can see it performed exactly as intended. On day one, it returned -10% (2 * -5%), and on day two it returned 10.5% (2* 5.25%). Each day it delivered 2x the daily index return. However, the total return for the LETF over the two days is -0.55%, as compared to 0% for the index. A small difference, sure. But, play that scenario out across 252 trading days, and the differences can be dramatic. 

Again from the UPRO prospectus:

UPRO Prospectus

Clearly, the one-, five-, and ten-year returns do not equal 3x the S&P 500 Index returns. And, you can see that over 2020, the 3x LETF meaningfully underperformed the index, which could have been caused by the increased volatility from the onset of the COVID-19 pandemic.

This deviation from target return can be positive as well, albeit usually over shorter time periods.  In upwards-trending markets, the difference between the underlying index and the LETF is positive, and that positive difference can be compounded over time. This can cause the LETF to deliver returns in excess of its target exposure. Here is an example from Fidelity:

Fidelity: borrowed from The ETF Handbook

The market was up 10% for 10 days in a row. The index returned 159%, while the 2x LETF returned 519%. That is over 3 times the return of the index. LETFs can be a powerful tool in trending markets. 

LETFs and Composer

Regulators conclude that LETFs may not be suitable for buy-and-hold investors. And, I would tend to agree. If you want to buy into a portfolio and never look at it again, LETFs are likely not for you. If you don’t want to take the time to understand volatility drag, then LETFs are likely not for you. If you don’t have a structured way to build or manage your portfolio, then LETFs are likely not for you.

BUT, if you are interested in optimizing portfolios, building unique strategies, diversifying, volatility targeting, return targeting, and many other strategies, then LETFs may be a valuable tool. And, I would argue LETFs are better suited for Composer because of the implicit structure the platform provides. Composer can help manage volatility, dynamically backtest strategies, and automate trading. 

Tips on implementing LETFs with Composer might be a good future blog post. Stay tuned…