Leverage ETFs are perhaps the most destructive investments possible for a long term investor. The reason for their destructiveness is that leveraged ETFs are designed to track the daily changes of an index. Over time, the ups and downs of the index cause the leveraged ETFs to lose value regardless of where the index actually goes. A three year chart of the XLF (un-leveraged bank stock ETF), the Direxion Funds Financial Bull 3x (NYSEARCA:FAS), and Direxion Funds Financial Bear 3x (NYSEARCA:FAZ) is shown below.
Click to enlarge charts
Over the last three years, the XLF (shown in blue) has been roughly unchanged. One would think that the leveraged 3x bull [FAS] and 3x bear [FAZ] would be hovering around zero. Wrong, FAS is down roughly 75% while FAZ is down roughly 99%. How could these leveraged ETFs' performance vary so much from their tracking index over time? The answer is simple: compounding.
Let's assume that XLF, FAS, and FAZ all start at a price of 100. The next day the XLF rallies 20% to 120. After this, the FAS would be trading up around 60% to 160. The FAZ would be trading at 40. The following day, XLF goes down 20 points, putting it back at 100. From its 120 base, this move is a 16.7% loss. So the FAS goes down 3 * 16.7 which is 50.1%. The FAS goes from 160 down to 80. The FAZ goes up 3 * 16.7 which is 50.1%. The FAZ goes from 40 to 60. So while the XLF has essentially gone nowhere, both the leveraged bull and bear ETFs have gone down in value.
The volatility in the market is what makes it so that these leveraged ETFs go down over time regardless of how their tracking index does. A similar example is shown below using XLE ( un-leveraged energy ETF), ERX (3x Bull Energy), and ERY (3x Bear Energy) over the last six months.
While the XLE is down slightly, both ERY and ERX are down significantly. ERX is down 40% while ERY is down 20%.
The message here is that while leveraged ETFs are good trading vehicles for very short term traders, leveraged ETFs have no place in a long term portfolio. Those who argue for using leveraged ETFs as a "hedge" for a portfolio are wrong. These products simply do not work over the long term. Returns over the long run are more a product of volatility than of performance of the underlying index.