Leveraged ETFs For Buy-&-Hold Investors?

Leverage is powerful. It's even been argued that it should be a consideration for young investors. Given all the hype, buy-and-hold investors are trying to figure out how to get in on the action. ETFs are great, so would leveraged ETFs be even better?

First, What Are Leveraged ETFs?

Traditional ETFs look to match the returns of an index, leveraged ETFs look to amplify them.

SPY, a traditional index ETF is designed to match the returns of the S&P 500, SPXL, a tripled levered ETF looks to 3X them!

This is achieved through the use of debt and derivatives. The math to enable this is rather complicated and can leave you scratching your head.

Long Term Leveraged Investing

Over the long term, markets have historically returned about 10% a year. If we used a leveraged ETF, couldn't we get 30%? If this sounds too good to be true, because it is.

ETFs like SPXL do provide 3X returns, but only for a single day. Leverage ETFs are rebalanced daily, meaning the tracking will melt away for any period beyond that. This causes wild performance gaps between a levered and traditional ETF following the same index.

Let's say on Monday, at market open you invest $300 into 1 share of SPY and $300 into 1 share of SPXL.

Monday:

The S&P 500 rises 10%

SPY = 300 + 10% = $330
SPYXL = 300 + 30% = $390

Tuesday:

The S&P 500 drops 10%

SPY = $330 - 10% = $297
SPYXL = $390 - 10% = $273

On Monday, SPYXL perfectly replicated a 3X return of the index, hooray! However, when held for an additional day, you start to see the decay.

Over the two day period, the S&P 500 dropped in value by 1% ( $300 to $297). Logically, you'd think SPXL dropped by 3%.

In practice, SPXL dropped by a whopping 9% ($300 to $273). In only two days, the decay lead to such a wild deviation from the underlying index. It'll only get worse over time.

Keep It Simple

Leveraged ETFs were not built for buy-and-hold investors. These were made for speculators who want to trade in and out of the market. Unlike with traditional ETFs, you can't truly be passive. You'll need to constantly monitor your position (or risk losing a ton).

Fees are also a factor. Given all complexity involved in levered products, they cost a lot more to manage. SPY has an expense ratio of 0.0945%, while SPYXL costs 1.01%. That's more than 10 times the price!

When it comes to long term investing, it's best to keep it simple.

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