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The Case Against Leveraged ETFs

Tristan Yates profile picture
Tristan Yates

Tristan YatesTristan Yates and Lye Kok (IndexRoll) submit: The Leveraged ETF offensive is under way. A year ago, there were no leveraged ETFs in existence. Today, there are at least fifty leveraged ETF products in the marketplace and another fifty in the SEC/AMEX pipeline. By this time next year, perhaps every traded ETF will have a 2x leveraged counterpart. Are these leveraged ETFs suitable for retail investors? No, they are not.

In this article, we lay out the case against these products, based upon popular misconceptions of what exactly these ETFs provide, a hidden trap related to leverage, and the poor performance of related funds and of the ETFs themselves.

Note that this article updates a SeekingAlpha article posted about six weeks ago, and we’d like to thank the many readers who were kind enough to provide us with additional research and commentary.

The Daily Double

Leveraged ETFs are exchange-traded funds that are based upon well-known indexes, but that provide investors with additional leverage by using borrowed money. Their goal is to increase the return of the underlying index and provide a better return for the fund’s investors. Typically they provide $1 of debt for every $1 of investor equity, and are marketed as 2X funds.

Leveraged ETFs are implemented using financial derivatives, such as options, swaps, and index futures. All of these tools are available to individual investors, but are much more complex than traditional share buying and selling and require larger amounts of capital. Thus, the advantage of the leveraged ETFs for many investors is a reduction of complexity and lower capital requirements.

Two companies, Rydex and ProShares, dominate the leveraged ETF marketplace. They have offered leveraged investment funds for many years, and have recently repackaged these products into ETFs.

A listing of some of the more popular ProShares

This article was written by

Tristan Yates profile picture
Tristan Yates writes and consults on leveraged indexed investment strategies. He graduated from the INSEAD MBA program in Singapore with his friend and colleague, Kok Lye, and together they now manage the Index Roll (http://www.indexroll.com/), an investment advisory, research group, and web resource created to help individual investors build and manage ong-term leveraged index portfolios using LEAP call options.

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Comments (63)

good article...

one thing i don't think is stressed enough is that there is a capital/interest cost.... no bank counterparty will give you leverage for free.

so if you pay 3.5% interest and the underlying does 8% your return is 12.5% for double leveraged vs. 8% for underlying.

leverage is not "free" anywhere but that's by the far the biggest element of difference between double leverage etf vs. double the underlying.

as you said yourself, in the long term the difference between your theoretical double etf and double the underlying tracked very nicely. (there are certainly other areas where there is slippage - management fee, excecution etc.)

but the big difference is the leverage cost IMO... i could be wrong but i don't think i am
sorry, i apologize you do mention the interest cost in your article...

and you are the only commentator i've seen so far that does.

too many people look at the somewhat non-intuitive mathematics of daily leverage (implementing daily vs. then measuring performance annually for example) and then say that is mostly why the double leverage etf did 10% when the underlying did 7.5%.

management fees, interest cost and other slippage simply dwarfs the mathematics of double leverage etf's

double leveraged short etf's i think the arcane math makes a much bigger difference. some people lost 70% of their money on something that on the surface looks like they should have made 100%+. there were a few examples (double short china and double short r/estate from vague memory)

thanks for bringing up the interest cost because i've never seen it mentioned before.
09 Jun. 2012
simple way to beat this short the inverse fund you want to buy
IE you want to go long QQQ and be leverage 3x (TQQQ)
Short the SQQQ then you can profit on the maintance and other cost.
Just look at the difference for 1 day

TQQQ 47.25 +1.35 +2.94% Jun 8, 4:00PM EDT
SQQQ 51.20 1.56 -2.96% Jun 8, 4:00PM EDT
.02 % not much but it will add up
but look at gold much better return shorting vs buying
NUGT 12.37 +0.20 +1.65% Jun 8, 4:00PM EDT
Dust 43.69 0.91-2.04% Jun 8, 4:00PM EDT
.39% more for a single day that could make a big difference
Natural gas has much higher expense and shorting the inverse would be much smarter then buying
UGAZ 17.89 +0.40 2.29% Jun 8, 4:00PM EDT
DGAZ 74.53 -2.29 -2.98% Jun 8, 4:00PM EDT
.69 % more for a single day shorting inverse vs buying ;)
Profit off the maintance short ETF'S
Dirk Burhans profile picture
Great article, very informative... will file for reference use. Thank you!
16 Jan. 2011
Very informative article which is well laid out. I was going to buy some leveraged funds and noticed that their performance was living up to expectations even with the market upturn in the last 6mo, but didn't understand why. If I want leverage I will borrow the money and invest it myself.
@aspiring_beginner and angleabates... that's great that you're presently making money going in/out of the market using moving averages, just know that the market often moves in ways that quickly violate such "rules". The market tends to periodically kick such strategies squarely in the ass. The success patterns of such "rules" are usually temporary and most participants don't discover that fact until their 85% return has dwindled to -15% (or some such) when the so-called "rules" have changed.

My main struggle with the article is that it appears to conflate two things. It describes how 1) the daily settlement in these leveraged ETFs prevents them from matching the annual return of the underlying index, and 2) that this in turn prevents one from making money if one invests at the wrong time--such as when the market is at a high point. To me, these are two very true but unrelated facts. If one invests at a market high, one will lose money, at least temporarily--with or without leverage.

One ought to find success with leveraged ETFs provided one's average daily returns over the life of holding the ETF are positive (assuming 0% interest) or above the underlying interest rate/cost of leverage (e.g., 5.25% in Yates & Kok's article).

Given that one's actual daily returns are going to be random and unknown--but with an assumed mean and standard deviation, the ideal leverage amount can be found using the Kelly fractional betting formula. (I'm curious as to the origins of Gandulu's comment/formula above.) Using the Kelly formula and Gandulu's assumptions for return (10%), interest rate (6%), and daily fluctuation (1%), I find the optimum leverage amount to be around 1.6. This is below the 2x leverage in, say, SSO, which suggests you not invest your entire portfolio in an S&P-based 2x ETF. This 1.6 value is more conservative than Gandulu's result.

My question is: why invest in a leveraged ETF vs. simply buying the underlying index on margin? (Recall, as Tristan said above, that there's indeed an interest cost embedded in the leveraged ETF). I suppose the advantage of the ETF is that it is settled daily and so you're never going to get a margin call (and certainly not in the direct sense). It's also a way to juice the returns (and risk) of an RIA to which you couldn't otherwise apply margin.
aspiring_beginner profile picture


You and angelabates are the only two who seem to "get it".

aspiring_beginner profile picture
A CORRECTION: I was thinking in terms of a "bear" 2X fund. For that type of instrument, then yes, if the index goes down 50%, the ETF share price goes down a THEORETICAL 100%.

I'm not sure what the math is for a Bull 2X fund. I think that maden might have the math right on that one.

aspiring_beginner profile picture

Yep. But why are you thinking about an index going down 50% in one day? 1987 was 25%.
aspiring_beginner profile picture

Right On.
aspiring_beginner profile picture

The only thing that matters, really, are percentages. And most of the major INDEX BASED ETF'S do an excellent job at tracking the indexes almost perfectly, at least within a short term, say less than a month.

I use TZA and TNA, both are 3X. If the Russell 2000 (the underlying) moves up 1%, the TNA moves up 3%, almost exactly. There is sometimes a tiny "bleed", what some people call "decay", but it is trivial over short time periods.

I recommend doing a spreadsheet using REAL WORLD ( NOT simulated) levels of the Russell and the TZA and TNA products. Do your spreadsheet for 1, 2, 3, and 4 weeks. You'll find that the total cumulative percentage moves of the ETF and the Russell are virtually identical (or triple if using TNA and TZA).

aspiring_beginner profile picture

"The secret to profiting from this game is to develop and follow a strict technical trading methodology. I use short term moving average crossovers as the indicator of market pivot points, thereby profiting on up as well as down swings in the underlying market. "

Finally, an intelligent comment on the subject. You are so right on, it is amazing. This is exactly what I do, and it works fantastically. Congratulations. You're the first person (and I've read hundreds) who have gotten this very simple concept right.

I agree with absolutely every word you wrote. My techniques are virtually identical. I use a 5 Simple DMA with 3.5% Moving Average Envelopes. I've made 84 % in ten months.

aspiring_beginner profile picture

" Are these leveraged ETFs suitable for retail investors? No, they are not."


Your whole article is full of so many errors I can't begin to address them all.

Please search for and read all my many posts on the Leveraged ETF's.


I get the fact that holding Leveraged ETF's for > 1 day is risky however, there is a scenario in which it is beneficial for one to hold these investments beyond one day. The scenario I am talking about is if your are relatively certain their will be a "run" in either direction, however banking on the run and its excess return needs to be compared with the downside. The downside is extreme so squeezing this for the little extra return is not worth it. Just wanted to put this scenario out there though.
Goal of almost every leveraged fund is to return a multiple of an underlying index/sector/group on a DAILY basis. Holding beyond that time period has more risk-- MUCH more risk...

One of the risks of ANY fund is that it may not achieve it's Goal. Market efficiency does not hold the Leveraged ETF (LETF) to the same standard as exchange traded stocks, or even ETFs in a derivative fashion.

Using these LETFs in a different way than what is intended (and published in disclosures) - will likely lead to losses if the position is not VERY closely tracked.

There have been recent law suits initiated by people who have purchased these types of instruments and have been surprised that their goals (appreciation over periods longer than a day) have not been met. An interesting link that discusses this in more detail.


I Use LETFs and love them but rarly if ever hold overnight.
I was wondering if someone can help me with this:
Today I was following UYG ProShares Ultra Financials & the index it tracks ^DJUSFN. According to all the posts I have read, the daily return of UYG should mirror 2x the ^DJUSFN. However, at the close today UYG was -.03% and ^DJUSFN was +.07%. UGY should have reached +.14% at the close because the trade duration was only one day, but this didn't happen. Was this because there was more leverage on under performing stocks in the UYG ETF? Or is there something else at play here? Thanks.
dirtyharry profile picture
Here's an idea: Since the bias is DOWN for both long and short leveraged ETFs, why not go with the flow? When the market hits interim highs, sell short the leveraged LONG version of the ETF and never go long (buy) on either the leveraged long OR short version of th ETF. By only trading these at perceived market tops and only shorting the levereaged longs, the long term bias down is always working in your favor when you execute this trade.
Soon, there will be MONTHLY leveraged ETFs and they will be designed to track the indexes x2 or x3 but on a monthly basis. This will help ease the concern about the compounding and volatility issues.
To those who think these are a good long term investment for your IRAs, etc., I would say that if it trends your way consistently, you will do well, but if there is choppiness and volatility along the way, you would actually do better in the 1x ETF! It's just a matter of math and compounding.

FAZ and FAS are the perfect example or the perfect storm AGAINST 3x ETFs. First FAZ skyrocketed as the financials plummeted. But then it plummeted as the financials recovered. The result of that huge up and down wrecked both FAS and FAZ.

If the market goes up and down, BOTH leveraged ETFs will lose.
Shorting both sides works if you expect up and down market for your time frame. But if the market trends one way, you will lose more on the uptrending one than you will gain on the downtrending one. If you've got deep pockets and can hold on until the uptrending gone comes back down, you will do well.
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