Why you should avoid leveraged ETFs

If someone offered you the chance to double, triple or even quadruple your returns, you might be tempted. However, get-rich-quick investment schemes almost always come with a catch. 

Leveraged exchange traded fund (ETFs) are a case in point. While the potential gains are eye-catching, in reality the funds rarely deliver results for private investors – quite the opposite.

The risks are built into the design of these funds. Leveraged ETFs buy options and futures, using borrowed funds, to gear up their returns. They are intended to be traded daily, and are only really suitable for institutional traders with access to significant market data. Despite this, they are available to buy on many retail investment platforms. Investors usually only have to answer a few simple questions to self-certify that they have the knowledge required to invest in these products.

On a basic level, they work as follows. Say you have a three times leveraged ETF: on day one you invest £100, and the market goes up 10 per cent. Excluding transaction fees, your investment is worth £130 by the end of the day. However, on day two the market falls 9 per cent and you end up with £94.90. You suffer a 27 per cent loss as the 9 per cent fall is tripled. 

If you had instead invested in an unleveraged but equivalent product, by the end of the first day you would have £110. On day two the 9 per cent loss would bring the value of your investment down to £100.10. Unlike the leveraged product, you do not make a loss. 

Amplifying this is the impact of daily rebalancing. As leveraged ETFs are designed for day trading, they rebalance their portfolios every day to preserve their target level of leverage. This makes them unsuitable for the vast majority of retail investors, who typically hold their investments for a longer period, as it means their exposure to the underlying market can significantly increase or decrease over time. Consequently, the performance of the fund can behave very differently to the performance of the original index or stock, and losses can be exaggerated. 

This becomes even more pronounced if there is significant market volatility. “If you get a whole load of volatility, but the index ends up more or less where it was, then you likely end up losing money because of the leverage, even though the value of the index hasn’t necessarily changed,” says David Liddell, chief executive of IpsoFacto Investor. Another thing to factor in is costs, as these are usually higher than for unleveraged options.

Leveraged ETFs tend to focus on specific asset classes or a particular index, but whatever their focus their use is still unlikely to prove fruitful. “Given the random nature of market moves on a day-to-day basis, I would say that unless you have a good Ouija board you should definitely steer clear of all these all levered daily exchange traded products (ETPs) regardless of whether they follow stocks, crypto or commodities like gold, copper or pork bellies,” Peter Sleep, an investment director at Callanish Capital, says. 

In essence, it’s better to think of leveraged ETFs not as investment vehicles, but as gambling products. So, if you fancy a flutter go ahead. But as Sleep suggests: “Go to Epsom rather than gamble on leveraged ETPs. You will have a day out in the fresh air and probably have more fun.”