Leveraging with ETFs

The Effect of Leverage with ETFs

While most ETFs trade in cash, and do not offer any leverage, some ETFs do employ a bit of leverage, where those who hold shares in the ETF control twice as much of the underlying asset as they would without the leverage.

What happens here is that the fund only puts up half the money for the assets that the ETF controls and borrows the money to buy the other half. Unlike individual investors trading with leverage, for instance with buying stocks, investors are not putting up margin or are subject to margin calls, so this is a bit of an advantage.

This is only an advantage really with those who are prone to let their positions move very big against them, and we only really get into this danger zone when an investment loses half its value with 2:1 leverage. Whether or not this is a situation that anyone should see themselves in or anything close to this kind of loss really, it will suffice to say that those who are in it to take on this much risk should never use leverage or even consider doing so.

ETFs also are able to borrow money a little more cheaply than individuals can, due to the volume of borrowing involved, measured in the billions of dollars out on loan at any one time with the largest leveraged ETFs.

Whether or not investors wish to engage in leveraged ETFs or not will depend not only on one’s risk tolerance but even more so on one’s time horizons. The longer a position is held, the less desirable leverage is, especially when these positions lack any real risk management, as is the case with the strategies of a great many investors.

Leveraged ETFs Are Not Exactly Linear

While we may think initially that doubling the size of your position with 2:1 leverage would double both the risk involved and the return one would get, this isn’t really the case at all. Many traders use much higher leverage than this but the added costs of the leverage may not be that significant due to the ratio of their returns to the cost of borrowing, but with more conservative amounts of leverage and more conservative investing styles, this ratio does have a significant impact upon performance.

The incremental gain from an appreciation in the asset is net the costs, including financing and other management costs that the ETF involves. All of these costs get passed on to the investors of course, the shareholders of the fund.

When comparing an ETF to an index on an annual basis, investors are automatically down the management fees of the fund, and with leveraged ETFs, they are also down the costs of the leverage to the fund. If this adds up to 6% a year, for instance, then we would deduct these costs from the return, such that if the asset rose 6% we would break even.

Leveraging with ETFsWhen leveraged ETFs run in the negative, have down years for instance, then this cost gets added to the losses involved. This extra addition to the losses due to the leverage tends to have a larger impact on the bottom line than we may realize, because it costs money to borrow money and when you do you want to make sure that your rate of return is high enough to make sense of all of this.

To use an example to illustrate the magnitude of this, over a 10 year period where the S&P 500 increased an average of 6.83%, a leveraged ETF tracking the S&P 500 only reported a return of 6.73%.

This means that management fees plus carrying costs added up to over 6%, a pretty significant amount indeed. If the management fees are around 1%, then this means that the cost of borrowing over this time was 5%, which is going to have a big impact upon results to be sure.

If we assume that this is therefore the break even point, the point where the costs of the leverage and the benefits of it even out over time, when we apply this to the average gain of the index over the longer term, the expected benefits of this will be pretty negligible.

On the other hand, we’ve clearly increased our risk here, and not only doubled it but doubled it plus the additional costs involved. If the market declines by 10% in a given year for instance, we’re out 20% plus this 6% cost, for a total of 26%.

Comparing Leveraged Trading with Leveraged Investing

This surely should have those who are using leverage to actually invest over a number of years some serious pause for thought, and even have us seriously wondering whether anyone should invest in leveraged ETFs. Leverage can be a phenomenally powerful tool to traders who are capable of multiplying market returns many times, but it really isn’t suitable for those who merely want to try to double market returns less the cost of the leveraging and their management fees.

As it turns out, 2:1 leverage is too tame to be able to leverage things enough to make real sense of leveraging. If, for instance, we were able to use 20:1 leverage instead, and we just traded an index fund, and the fund increased by the same 6% roughly, this would give us a gross return of 120%. The roughly 6% that it may cost us to do this is therefore going to be pretty insignificant.

We’re still left with a net return of 114%, as opposed to these costs eating up our entire 6% nominal gain with the 2:1 leverage. This is why the ratio of the total return to the leverage cost is so important, because the total return must be larger enough by several times on average to even begin to make sense of doing this.

Investors could never invest with 20:1 leverage or anything close to that, and in fact, any leverage is too much when you invest. The reason is that their strategy requires that they give at least a wide berth to their investments, where traders can use much tighter constraints with their trades.

With 20:1 leverage, a move of a mere 5% will wipe you out, and investments drop by that much quite frequently. Top traders will exit their positions much more quickly than this, when they are down only a fraction of a percentage, typically limiting their losses on a position to just a percentage or two. Traders who risk more are the ones that tend to bust their accounts as accepting larger losses than this is a recipe for disaster.

This degree of leverage is really only suited to intraday trading, and even keeping a position for more than a few hours, and never overnight, would be excessively risky. This is a far cry of course from the world of investors who measure the length of their positions in years, not hours.

The longer one is in a position, the less leverage one can effectively or even safely use. The less leverage we use, the less effective it is, to the point where 2:1 leverage really isn’t effective at all when we account for the average movement of indexes or anything else for that matter.

These assets just don’t move enough over time, on average, to justify the cost of the borrowing involved in leveraging, and we end up with marginal benefits at best and more than double the risk.

Why People Invest in Leveraged ETFs

Most investors do not have much of an idea of the dynamics of investing, and more or less go with the crowd. If the crowd is marching toward a cliff, they will simply follow along, much like a herd of buffalo may do.

It really doesn’t take much effort to discover that leveraged ETFs are not a good idea, because all you need to do is look at the history of the fund you are considering, and then compare its results with the index it is tracking, while also taking into account the added risk of the leveraging.

It is too much to expect that anyone will be able to track an index and get the same returns because this is going to involve costs of some sort. Even with the tightest spreads, and not paying any commissions beyond that, such as a CFD would offer, CFDs do involve significant costs of borrowing and are not suitable at all for investors.

This is because the risks involved simply cannot be managed by investing, as this requires quick exits and investors generally don’t exit very often if at all.

In the long term though, given that indexes do tend to go up, at least without the prospects of margin calls, one can stay the course in a similar way as one would do with a non leveraged investment and wait out the bear markets.

If the index does average enough so that one at least breaks even over time, which would seem to be around the 6% level, then this might not seem so bad. If the index beats this over time, and it has beat this a little over the long term, one is left with a decent profit from the leverage.

So, leveraged ETFs may not be all that bad, provided one does have a long enough time horizon, but all this extra risk does need to be accounted for regardless. We can’t just ignore risk just because we’re going very long term.

If this trend does not continue during our time horizon, if the market underperforms this level or even ends up in the negative, this additional risk will come home to roost and may do so in a very ugly way, and we may lose a lot more of our principal than we would have had we not leveraged our investments.

Therefore, with all things considered, it is hard to imagine how leveraged ETFs make sense from a longer term perspective at all. In a way, you are betting the farm on the long term uptrend continuing anyway, and if you are wrong, you are in trouble already. Adding to this trouble very significantly, more than doubling it, is a whole different world of hurt though and this should be taken well into account.

It’s not even that leveraged ETFs make that much sense for medium term investors either, as the year over year results are well impacted by the costs of leverage, and we even see situations where the market has gone up but a leveraged ETF has lost money, and this even can happen over a single day as well.

Those who hold leveraged ETFs or are considering investing in them need to at least spend some real time and thought examining the implications and expectations of this, and when they do, they will likely come to the conclusion that leveraged ETFs are not really a good idea for anyone who is planning on holding investments for any significant amount of time, and perhaps not even for anyone period.

Ken Stephens

Chief Editor, MarketReview.com

Ken has a way of making even the most complex of ideas in finance simple enough to understand by all and looks to take every topic to a higher level.

Contact Ken: ken@marketreview.com

Areas of interest: News & updates from the Federal Reserve System, Investing, Commodities, Exchange Traded Funds & more.