Why Leveraged ETFs Are Designed to Lose Money Over the Long Term

Brokers on the New York Stock Exchange floor

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Over the past few years, there has been increased concern about the number of times inexperienced investors buy leveraged exchange-traded funds within their personal portfolios. These specially created financial products are designed for speculators and have been twisted into something that individuals are buying or trading without any comprehension of how they actually work. 

That's dangerous because many leveraged ETFs are not structured like ordinary ETFs. They are meant to be held for a maximum period of a single trading day. Beyond that point, the longer you own it the probabilities become higher and higher that you'll lose money as a result of the structure employed.

An Overview of Regular ETFs

An ordinary ETF is just that - an exchange-traded fund. It's a pooled mutual fund that owns an underlying basket of securities or other assets, most often common stocks. That basket trades under its own ticker symbol throughout the ordinary trading day the same way shares of Johnson & Johnson or Coca-Cola do. 

From time to time, the net asset value (the value of the underlying securities) may deviate from the market price but, on the whole, the performance should equal the underlying performance over long periods minus the expense ratio. Simple enough.

Leveraged ETFs TQQQ Change Over the Long Term

With a leveraged ETF, on top of the (usually modest) asset management fees, frictional expenses such as trading costs, and custody fees, you have the interest expense of the debt used to achieve the actual leverage. That means that every moment, of every day, interest expense or its effective equivalent is reducing the value of the portfolio. Let's take a look at one such ETF, the UltraPro QQQ [NASDAQ: TQQQ], which leverages the S&P 500 index 3-to-1.

If the market goes sideways, the ETF's shares are destined to lose money, a reality that is exacerbated by the fact that the portfolio rebalances daily. That last part might seem trivial, but if you are particularly good with math, you'll have already understood the implications.

Even if the market ends up increasing in value, and even if you are leveraged 3x on that increase, the combination of daily rebalancing and how it harms you during periods of high volatility, plus expenses, plus interest costs means that it is possible, perhaps even likely, that you will lose money, anyway. 

To put it bluntly: You could be right, the market could increase, and you could still lose money; maybe even a lot of money.

Who Should Consider Leveraged ETFs?

For whom, precisely, are these leveraged ETFs designed? What types of people or institutions should consider buying or selling them? In the end, the answer becomes clear when you understand that they aren't meant for investment at all. 

Investing should involve owning shares of companies and collecting dividends or lending money and collecting interest income, and it is necessary for the functioning of the real economy. 

The purpose of leveraging a stock market benchmark, such as the S&P 500, by 300 percent and then resetting it every day is a way to gamble without risking the dangers of directly employing margin debt. You can take the long side (bet that it will increase) or the short side (bet that it will decrease) as both have their own respective ticker symbols. The ETFs are meant for those with deep pockets who can afford to take the outsized risk and are willing to bet that stocks will go up or down on any given day.

Why New Investors Should Avoid Leveraged ETFs

What is the takeaway of all of this for new investors? To put it in the clearest possible terms:

  • You have no business, under practically any set of circumstances, to have any sort of leveraged ETF in your portfolio.
  • If you ignore this first point, don't make the mistake of buying a leveraged ETF and holding onto it for more than a single trading day. These instruments are internally constructed to lose money the longer you hold them, so don't fall for the illusion they are like stocks or bonds. For each day they sit on your books, the more dangerous they grow. You cannot convert what is meant to be a gambling tool into an investment opportunity.

Unless you are a professional, dump the leveraged ETFs immediately. You're playing in a sandbox you likely don't understand and you will suffer for it. You likely will lose your wealth and you will have no one but yourself to blame. That may sound rather "line in the sand," but this is one of those areas where there is no room for disagreement among reasonable people. Stop trying to be clever and be content to enjoy the riches that long-term investing can bring you.