In the investing world, returns are always in demand, but the path by which investors pursue these returns can be very detrimental to a portfolio’s health. Leveraged funds, which have been around for two decades now, seek to beat the market returns of their unleveraged, index-tracking counterparts by essentially increasing the stakes of the bet through the use of derivative instruments. The idea seems straightforward, but the results are not always what investors expect them to be.
Index funds have become an immensely popular investment vehicle due to their built-in diversification and relatively low cost. With that said, their leveraged counterparts cost considerably more due in large part to the derivatives involved in making these products work. These double and triple leveraged versions of the same funds also give investors the illusion that they can achieve two times or three times the underlying index’s return. However, because the majority of these funds rebalance daily, they don’t exactly perform as their names indicate over long frames – especially when there is heightened volatility and negative returns are involved over the holding period.
Let’s look at a hypothetical example:
One of your holdings, a $100 position in an unleveraged biotechnology ETF, moves up by 10% today and then promptly drops by 10% tomorrow. As investors are well aware, this isn’t exactly a wash. After the first day, your investment grew to $110, but after the following day’s decline, the position is now worth $99, or 1% below what you started with. If you had invested in the same product, but with double leverage, that investment would have gone from $100 to $120, but then down to $96. By doubling your leverage then, what most investors don’t realize is that the loss widens from 1% to 4%!
Market downturns are inevitable; however, with volatility in the mix, these products make it more of a bet suited for day traders than a wise investment for buy-and-hold investors who have a long-term time horizon. “Boring” unleveraged funds are perfectly fine the way they are for several reasons including their low cost, but falling into the temptation of owning leveraged funds is chasing fool’s gold with little to gain and much more to lose.