No product on Wall Street draws more criticism than leveraged ETFs. Leverage funds are designed to multiply the performance of indexes, but often do so poorly in the long run.

The ProShares Ultra S&P500 ETF (SSO) tracks twice the daily return of the S&P500 index every day. If the S&P 500 is up 1%, then SSO should be up 2%. If the S&P 500 is down 2%, then the SSO ETF should be down 4%.

Just how well this tracking works can be seen in a since inception chart comparing the two:

The S&P 500 was up nearly 16%. SSO was down nearly 14%. Why the disparity?

### Leveraged ETFs Lose from Compounding

Compounding, the very thing that is supposed to make investors rich in the long run, is what keeps leveraged ETFs from mimicking their indexes in the long haul. Simple mathematics can explain why leveraged ETFs fail to keep pace.

Suppose that the S&P 500 index were to lose 10% on one day, and then gain 10% the next day. (Rarely do big moves like these happen, but it helps illustrate the point – round numbers are easier!)

So, if the S&P 500 starts at the round value of 1400, it would lose 140 points on day one to close at 1260. The next day, it would rise 10%, or 126 points, to close at 1386. The total loss from this two day move is 14 points, or 1%.

Supposing that SSO started out at a value of $60 per share, SSO should lose 20% of its value on the first day. The ETF would close at a value of $48. The next day, it should rise 20% from $48 to $57.60 per share.

At the end of this two day period, the S&P 500 would have lost 1% of its value. By contrast, the SSO ETF would have lost 4% of its value.

### Danger of Multiplication

The order in which we do this operation does not matter. Try this out: using the round number of 100, subtract 10%. You arrive at 90. Then add 10%. You get 99. If you reverse the order and add 10% to 100 before subtracting 10%, you get the same result – 99.

The decay happens even faster when you use larger numbers. Subtract 50% from 100 before adding 50%. You’ll get 75.

But let’s get into the real fun. What if you have several days in a row of movement in the same direction? If the S&P 500 index were to move up 2% a day for 10 days straight, its ending value would be 21.8% greater than its starting value.

A 2x leveraged ETF like SSO would move up 4% a day for 10 days straight and thus its ending value would be 48% higher than its starting value. SSO’s return of 48% is greater than two times the 21.8% return of the S&P 500 index.

### Volatility Destroys Leveraged ETFs

The problem is that the market does not move up or down in a straight line. Instead many daily positive and negative moves produce – hopefully! – a positive return in the long run. Exchange-traded funds that track and compound the daily moves, however, always lag their index (and eventually produce negative returns) in the long run.

Triple-leveraged ETFs decay much faster than double leveraged ETFs. For example, Direxion’s TNA fund tracks 3x the daily change in the Russell 2000 index. Since the fund was launched in late 2008 it delivered a lackluster 32% return compared to the Russell 2000 index, which delivered a 66% return. Despite leverage of 3x, the leveraged fund gained 32% to the index's 66% return.

### How to Juice Returns Safely and Reliably

The only “safe” way to leverage a portfolio is to open a margin account. If you had $50,000 to invest and wanted twice the return of the S&P 500 index, you could buy $100,000 of the S&P 500 index ETF (SPY) on margin.

Since you actually own 2x the amount of the ETF you want to double, you can guarantee that you will get twice the return (minus the cost of interest on your margin account.) You cannot guarantee that a leveraged fund will provide double the return over time.

Buying and holding leveraged ETFs is playing with fire. They are designed for day traders… In the long haul, you're certain to get burned.

W at Off-Road Finance says

This explanation doesn’t seem right to me. There is slippage, but I would argue it’s not for the reason you suggested. The difference between the ETF in a margin account and the 2x ETF is that the 2x ETF maintains constant leverage and the margin account does not.

Suppose you had a $10,000 account, bought SSO, and the market went down 10%. You’d have $8,000 left in the account and $8,000 of SSO representing 2x leverage so $16,000 of underlying.

Now say you took the same account and bought $20,000 of SPY on margin and it goes down 10%. You’d now have $18,000 of SPY in an account with a liquidation value of $8000 – an extra $2000 of underlying for a leverage of 2.25. Your leverage would have increased. In other words, the margin account doubles down on drawdowns “automatically” whereas the ETF pins your leverage at 2x.

That’s why they don’t get the same result. Certainly the margin account is not safer. Nor is the 2x ETF giving you some sort of bad deal.

JT says

I agree with you on the leverage mathematics. The point at the end is that if you want 2x the return of a particular index from time A to time B, the best way to get that return is to use margin on the underlying, not to use a daily levered ETF.

For example, if you want to make a directional bet which rewards you with 2x the S&P500’s return from January 1, 2013 to some point in the future, margin would be much better than the 2x daily levered fund. You’re not going to get 2x the total return from January 1, 2013 to January 1, 2014, for example, with a leveraged ETF. You will get it with margin.

I should have been more careful with the word “safe.” I should have said that the only way to guarantee twice the return from A to B is to use margin, not a double-levered daily compounding ETF.

There is no way for a retail investor to inexpensively rebalance a leveraged ETF position (you’d have to do it daily) so that it mimicks a margin trade over a period of many weeks or months. Margin would be more cost-effective, unless you want to put tens of millions of dollars to work in the trade.

Jason says

I’m going to do a post fairly soon on Actual rate of return versus Average rate of return. It’s quite interesting and plays a little into what you’re talking about. Those downswings in the market certainly hurt the actual return one will see.

Leveraged ETFs can be a great thing in an up market, but if you’re taking double the losses then it’s tough to offset that…even with getting double the gains.

Andy Hough says

This sounds like an investment I want to avoid. I prefer my investments to not be too volatile.

Darwin's Money says

If you just model a 1X and 2X in excel over time, you’ll see why the value decay occurs; it’s simple mathematics. Agree w JT, you can’t hold these long term, especially in a flat market.

Sunny K says

Hi JT,

Thanks for the great article. I understand your rationale above about the risks of leveraged ETFs. However, when I compare the change in share price of a leveraged ETF vs the non-leveraged version of that same ETF I see large differences in increase of share price that favors the leverage ETF.

For example, for MVV (ProShares Ultra MidCap400) which provides double the returns, increased from $7.05 on 3/6/09 to $83.26 on 6/19/15.

The non-leveraged equivalent MDY (SPDR S&P MidCap 400 ETF Trust) went from $82.12 on 2/1/09 to $277.69 on 5/1/15. These numbers are from Yahoo Finance.

So if you hypothetically got into the market right after the 2008 crash it would seem that if you just held on to MVV you would have increased your money 18 fold vs just 3.5 fold with MDY.

Now I can tell by the stock charts there was a lot more volatility along the way with MVV, but it seems that if you stayed the course it would have payed off handsomely.

Maybe I am missing something. Any thoughts?

Thanks

Sunny