Leveraged ETF Decay: Why It Happens and How to Avoid It

Leveraged ETF decay is a common phenomenon where the performance of leveraged ETFs diverges from their intended target, often resulting in significant losses. This decay can be attributed to the compounding effect of daily rebalancing, which amplifies the difference between the ETF's target and actual performance.

The compounding effect of daily rebalancing is a major contributor to leveraged ETF decay. This is because the ETF's underlying assets are rebalanced daily, which can lead to a snowball effect that further widens the gap between the ETF's target and actual performance.

To put this into perspective, a 2x leveraged ETF that aims to double the daily return of its underlying index will actually lose value over time due to this decay. For example, if the underlying index returns 1% in a day, the 2x leveraged ETF will return 2%, but the next day it will need to return 2.04% to maintain its 2x leverage, resulting in a loss of 0.04% or 4% of its original value.

Leveraged ETFs are designed to multiply the daily returns of an underlying index, but this comes with a catch. They can decay over time due to daily resets and compounding losses.

Gains and losses are compounded daily, which means that even if the underlying asset remains stable, the leveraged ETF can move away from its true performance. This is because the ETF is reset and calibrated back to the underlying asset every day.

For example, a 2x leveraged ETF is set to double the daily performance of the asset it's tied to. If the underlying asset increases by 1%, then the 2x leveraged ETF increases by 2%. If the asset increases by 3.5%, then the 2x leveraged ETF increases by 7%.

Several bad days in a row can lead to significant losses, even if the underlying asset remains stable over time. This is because the daily resets can compound losses in certain market conditions and time horizons.

Here's an example of how this can play out:

The key takeaway is that leveraged ETFs are not a substitute for traditional investment strategies. They can be highly volatile and may not perform as expected, especially during times of market stress.

Decay risk creeps in when holding a leveraged ETF beyond a couple of days or weeks.

Clear targets for entry and exit points are essential before investing in a leveraged ETF. Consider the reduced time horizon when developing a strategy and pricing targets for a potential short-term move.

Frequent monitoring of your position is recommended, especially in volatile markets, where situations can evolve rapidly.

The constant leverage trap occurs when most leveraged ETFs reset to their underlying benchmark index on a daily basis, resulting in a situation where a security price will eventually decline enough to cause terrible damage or even wipe out highly leveraged investors.

The Dow Jones dropped about 22% on one day in October 1987, and if a 3x Dow ETF had existed then, it would have lost about two-thirds of its value on Black Monday.

Compounding in leveraged ETFs can cause significant gains or losses over time, with a 3x fund going up 15% and down 15% on consecutive days, resulting in a loss of 2.25% on an investment that would normally track the benchmark without leverage.

Volatility in a leveraged fund can quickly lead to losses for an investor, with the ProShares Ultra S&P 500 (SSO) losing 40% of its value between January and March 2020.

Volatility can quickly lead to losses for investors in leveraged ETFs. Compounding, the cumulative effect of applying gains and losses to a principal amount of capital over time, is a clear risk for 3x ETFs.

The process of compounding can cause significant gains or losses in leveraged ETFs. For example, assume an investor has placed $100 in a triple-leveraged fund. Consider what happens when the price of the benchmark index goes up 5% one day and down 5% on the next trading day. The 3x leveraged fund goes up 15% and down 15% on consecutive days.

This can result in a loss of 2.25% on an investment that would normally track the benchmark without the use of leverage. The effect of compounding can often lead to quick temporary gains, but it can also cause permanent losses in volatile markets.

The ProShares Ultra S&P 500 (SSO), which follows the S&P 500 with 3x leverage, lost 40% of its value between January and March of 2020. This is just one example of how volatility can destroy returns in leveraged ETFs.

A 2x leveraged ETF like SSO would move up 4% a day for 10 days straight and its ending value would be 48% higher than its starting value. However, if the market moves up and down in a straight line, the net returns after the 2 days are given by a loss of 4% of its value.

Decay becomes more prominent the longer you hold a leveraged ETF. While the effects of it may be minimal in the short term, it can compound overtime and lead to an unexpected deviation from the underlying asset.

High Expense Ratios can be a significant risk for investors. Triple-leveraged ETFs often charge around 1% per year.

The ProShares UltraPro QQQ (TQQQ) has a gross expense ratio of 0.98%, which means investors will lose 0.98% of their returns each year to cover operating expenses.

Even a small difference in expense ratios can add up over time. For example, the Invesco QQQ (QQQ), which tracks the same index as the TQQQ, has an expense ratio of 0.20%.

A 0.78% difference in expense ratios may not seem like a lot, but it can cost investors a substantial amount of money in the long run.

Managing risk with leveraged ETFs requires a clear understanding of their short-term nature. These funds are meant to be traded in short-term windows, typically a day or two.

The longer you hold a leveraged ETF, the more decay risk starts to creep in. This is because the performance of the ETF can drift away from the underlying asset over time.

Frequent monitoring of your position is essential, especially in volatile markets. Situations can evolve rapidly, so it's best to keep a watchful eye over your investments and act accordingly.

It's crucial to have clear targets for entry and exit points before investing in a leveraged ETF. This will help you manage your risk and avoid holding the fund for too long.

Investors usually hold leveraged ETFs for a day or two, sometimes up to 10-14 days on the longer side. This is because the decay risk is substantial, and the longer you hold, the more noticeable it becomes.

Leveraged ETFs can be incredibly volatile, and their decay can be catastrophic. A 22% drop in the Dow Jones on one day in October 1987 would have wiped out a 3x Dow ETF.

The constant leverage trap is a result of daily resets, where the ETF's value is adjusted to maintain a fixed leverage ratio. This can lead to a situation where a security price decline causes terrible damage to highly leveraged investors.

The Dow Jones' 22% drop on Black Monday would have resulted in a 2/3 loss for a 3x Dow ETF. If the underlying index declines by more than 33% on a single day, a 3x ETF would lose everything.

Leveraged ETFs can be a double-edged sword, and one of the most significant risks is decay. This occurs when the ETF's tracking error increases, causing it to underperform its benchmark.

In a normal market, decay is relatively low, around 2-3% per year. However, in times of high volatility, this can jump to 10-15% or more. This can significantly eat into your returns.

The longer the holding period, the more decay can accumulate. For example, if you hold a 2x ETF for a year, you can expect to lose around 4-6% to decay.

It's essential to consider the potential for decay when investing in leveraged ETFs, as it can have a significant impact on your portfolio's performance.