Leveraged ETFs have gained traction in recent years. They are designed to amplify the return of regular ETF products, which can be 2x or 3x.

There are hundreds of leveraged ETFs covering almost every asset class, index, and industry sector. The most popular ones track the performance of major benchmark indexes like the S&P 500 Index or the Nasdaq 100.

However, you may have experienced the following scenario: you've held a leveraged ETF that tracks a benchmark index for some time. The index remained almost the same, but your leveraged ETF fell, causing you a loss.

You may wonder what went wrong?

This article will explain what leveraged ETFs are, their benefits, and their risks.

01 What are ETFs

Before we dive into the topic, let's take a few minutes to review the basics of ETFs first.

An ETF, or an exchange-traded fund, is an investment fund traded on an exchange like a stock.

One of the features of ETF is that its performance is generally expected to mirror that of the index it closely tracks.

For example, $SPDR S&P 500 ETF (SPY.US)$ and $Invesco QQQ Trust (QQQ.US)$ are the two most popular ETFs, which track the performance of the S&P 500 index and the Nasdaq 100 index, respectively.

If the S&P 500 index increases 1% in a month, SPY is generally expected to be up 1%, and the opposite is also true. (However, it should be noted that their performance may not be identical due to fees and expenses associated with the ETF).

That's because SPY's holdings consist of all stocks in the S&P 500, including Apple, Microsoft, Amazon, and more.

Here, let's share a tip for ETFs:

The S&P 500 index is a market-capitalization-weighted index, which means companies with larger market capitalization exert a greater impact on the index value, while those with a smaller market capitalization carry less significance. Therefore, large-cap stocks tend to have a greater impact on SPY.

The chart below shows the weight of SPY's top 10 positions. You can see that Apple is ranked first, followed by Microsoft. Therefore, Apple's price movement will have the greatest impact on SPY.

02 What are Leveraged ETFs

After recapping the ETF basics, let's dive right into the leveraged ETFs.

Unlike a benchmark ETF designed to mirror or track the performance of the underlying index, a leveraged ETF seeks to mirror multiples of the underlying benchmark index on a daily basis.

To achieve this objective, leveraged ETFs employ various investment strategies, such as swaps, futures contracts, and other derivative instruments.

An example of a leveraged ETF is the $ProShares UltraPro QQQ ETF (TQQQ.US)$ , which aims to deliver three times the daily returns of the Nadasq 100 index.

In other words, if the Nasdaq 100 is up 1% within a day, TQQQ should be up about 3% that day. Conversely, if the index falls by 1%, TQQQ will also fall by 3%.

The chart below shows the performance of the Nasdaq 100 Index (NDX) and TQQQ on February 14, 2023.

We can see from the chart that the Nasdaq 100 index closed at 12,590.89 points that day, up 0.71%. TQQQ closed at 25.49 US dollars, up 2.16%, an increase of about three times the Nasdaq 100 index.

However, although leveraged ETFs provide amplified returns on a daily basis, holding them over the long term may involve extra risks.

03 What might Happen if We Hold Leveraged ETFs for the Long Term?

One major risk of holding a leveraged ETF for the long term is volatility decays.

Leveraged ETFs are only designed to track the single-day performance of the underlying index. When held for the long term, the compounding effect may potentially expose investors to extra losses, especially in volatile markets.

Let's go back to our previous example of Nasdaq 100 (NDX) and TQQQ. The chart below shows their performance from September 9, 2022, to February 14, 2023

● The Nasdaq 100 closed at 12588.29 on September 9, 2022, then experienced a decline for a while and finally returned to the previous level at about 12590.89 on February 14, 2023. The return of the index during this period was about 0%.

● TQQQ closed at US$29.68 on September 9, 2022. It also experienced a decline and then went back up to US$25.49 on February 14, 2023. But the return of TQQQ during this period was about -14%.

As you can see, an investor would suffer an approximately 14% loss for holding TQQQ for about five months even if the Nasdaq 100 returned to the same level after a decline.

In addition, leveraged ETFs typically come with higher fees than traditional ETFs, which can eat into returns over time.

04 Understanding Volatility Decays

In order to better understand the volatility decays, let's look at a simple mathematical example.

For simplicity's sake, let’s assume the Nasdaq 100 index starts at 1,000 and TQQQ price starts at US$1000.

Suppose the changes of the Nasdaq 100 index for four consecutive days are: -10%, +10%, -10% and +30%. Four days later, the index will close at 1158.3, a gain of 15.83%.

Since TQQQ provides three times the daily returns of the Nadasq 100 index, the four consecutive days' changes for TQQQ are: -30%, +30%, -30%, and +90%, respectively. Four days later, TQQQ will close at 1210.3, a gain of 21.03%.

Though TQQQ's performance is still better than its underlying index in this four-day period, TQQQ's 21.03% return is less than the expected triple return, which should be 15.83%*3 = 47.49%.

05 Things to Consider Before Investing

In conclusion, leverage ETFs can potentially offer attractive returns in the short term. However, they may come with significant risks that make them unsuitable for long-term holding.

Therefore, before investing in leveraged ETFs, we should pay attention to the following:

● Leveraged ETFs may not be suitable for long-term holding, as volatility decay may erode returns and magnify losses.

● Leveraged ETFs are more suitable for day traders who want to amplify their returns. But traders need to have a high tolerance for risk as the changes of a leveraged ETF may be two or three times (or opposite to) the benchmark index.

● Furthermore, traders who bet on the underlying ETF should have risk management strategies in place and be ready to close their positions at the end of each trading day.