Earlier this month, the SEC approved an application to allow the launch of quadruple-levered ETFs in the United States. Reuters explained that:
[The SEC] approved a request to trade quadruple-leveraged exchange-traded funds, marking a first for the growing market for such products in the United States.
The request to list ForceShares Daily 4X US Market Futures Long Fund, under the ticker UP, and ForceShares Daily 4X US Market Futures Short Fund, under the ticker DOWN, was filed by Intercontinental Exchange, Inc.'s (NYSE:ICE) NYSE Arca exchange.
One of the funds is designed to deliver 400 percent of the daily performance of S&P 500 stock index futures, while another fund will aim to deliver four times the inverse of that benchmark. That means a fund could go up 8 percent on a day the index it tracks falls by 2 percent.
ETFs offering three times leverage already trade in the United States, but more reactive products have been limited to listing in Europe.
At first glance, this seems like great news right? For traders without access to futures or other more highly levered ways to make bets on market direction, this would give them that ability. Unfortunately, giving that access would probably lead to more bad than good.
The last thing most retail traders need is the facility to take more levered positions on the direction of the stock market. Market timing is a difficult game; few do it well. I firmly believe the stock market isn't a casino, contrary to what some left-wing economists may say. However, the more leverage you add, the closer you get to betting rather than investing. That said, we have free markets, and if people want to make highly speculative plays on the direction of stocks, it's probably going to happen regardless of the regulatory environment.
4x: Leverage Decay Would Be Severe
However, arguably the real issue with such leveraged funds is that they will perform horribly over time. The prospectuses on 2x and 3x leveraged funds tend to clearly note that these are not meant to be long-term holdings. Ideally, traders should just use these for day traders or short-term positions.
This is because, over time, the leverage causes massive slippage. Every day, the leveraged fund must rebalance its holdings to get back to its stated leverage ratio. Imagine, for example, that the SPY is at 100, as is the 4x-levered fund. When SPY rises 1%, it closes at 101. The levered fund had started the day with 100 in NAV, with which it holds 400 worth of SPY. At the end of the day, it now was a NAV of 104 with 404 units of SPY. It now has to buy 12 more to get back to 4x for the next day's trading. And the process runs in reverse as well; after the market declines, levered funds must unload exposure to get back to where they should be.
This is the literal definition of buying high and selling low, it's coded right into these funds' DNA. On a 2x-levered fund of something that isn't that volatile, the leverage decay is fairly slow, and thus doesn't cause a big hit to longer-term holders. However, as you ramp up both leverage and volatility, the losses from this slippage increase exponentially.
For one tragic example, consider a long-term position in either the 3x bull junior gold miners (NYSEARCA:JNUG) or 3x bear junior gold miners (NYSEARCA:JDST). They are both based on the gold mining juniors ETF (NYSEARCA:GDXJ). Here's a long-term chart of GDXJ:
Over a three-year span, it's pretty much gone sideways, albeit with a massive decline in 2015, and vigorous recovery in 2016. How did the 3x ETFs based on this underlying volatile ETF fare? They fared badly. Here's the bull 3x ETF:
JNUG data by YCharts
As you can see, the drop in late 2014 pretty much wiped the fund out. By the time gold miners finally recovered in 2016, the fund was starting from such a low point that even an historic rally only barely moved the needle.
JDST, the bearish ETF, did even worse. Yes, it had a couple of spikes as gold miners plunged, but the 2016 rally obliterated the fund. From early 2016 into summer, shares plunged from a split-adjusted 7,500 to almost nothing:
JDST data by YCharts
Leveraged ETFs can truly be a weapon of mass destruction if held for the long term. Most retail investors buying these funds simply don't understand the level of risk in holding these vehicles for more than a few days at a time.
Sometimes, they even blow up overnight. As I detailed recently, the Brazilian stock market just crashed. At this writing, the Brazilian ETF (NYSEARCA:EWZ) is down 15%. That's a massive blow - one of the worst one-day falls for Brazil of all-time - but survivable. The value of that equity can recover with time.
However, if you own the 3x long Brazil ETF (NYSEARCA:BRZU), there are decent odds that you'll never see your product trade back to where it was last week:
BRZU Price data by YCharts
The math is just so bad for these funds. BRZU will lose close to half its value today. That will force it to sell a large chunk of its assets at the close of trade locking in massive losses to get back to 3x levered (it currently has way too much exposure, given the brutal decline in NAV).
After a 45% decline, you need an 82% rebound just to get back to break-even. People look at the huge run-ups in levered ETFs from time to time and get greedy. But realize that the potential gains come with equally large potential losses - and it takes far bigger winners to recover your capital after a steep draw-down.
4x S&P 500: Somewhat Less Risky. Somewhat
Now the argument will go that these quadruple-levered ETFs aren't so bad because they are hitched to the S&P 500. The S&P 500 has experienced minimal volatility over the past few years, and thus the leveraged decay would be significantly less. The S&P 500 isn't prone to the same day-to-day swings as, say, the junior gold miners or emerging markets.
However, the risk of any stock market crashing is always there. In a 1987-style plunge, the 4x long S&P ETF would be virtually wiped out in a single day. The 2008 whipsaw volatility would have crushed the value of both these funds; even the bear fund wouldn't have performed that well since there were numerous huge bounces along the way. October 2008 alone witnessed two 10%+ rallies for US stocks, both of which would have slashed the 4x bear ETFs' value by 40% or more overnight.
One of these funds might perform well for a time (the up one in particular if the current bull market goes on for a while), but ultimately they are time bombs and would almost certainly explode sooner or later.
According to the Wall Street Journal, the SEC is now reconsidering whether or not to permit these 4x ETFs to launch. While these wouldn't be the worst products in the world - UVXY is still listed after all - they would almost certainly cause large losses to novice investors sooner or later. And really, in a world where the SEC won't allow a Bitcoin ETF, what's the explanation for ever-more-dangerously levered ETFs?
Disclosure: I am/we are short UVXY.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.