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Certain ETFs double the daily rate of return of certain indices. Can you use such ETFs to beat the market (not on a risk-adjusted basis, just in terms of pure returns)?

I have read that

When based on high volatility indexes, 2x leveraged ETFs can also be expected to decay to zero

But I don't see why this can be true.

My rationale is the following: My assumption is that typically, markets have a positive return expectation (otherwise, prices should drop such that this is true). If, on a daily basis, the expected return is positive then it should be profitable to double that return. And if this is true for one day, then surely this should be true for longer periods of time.

If you can win by following such a strategy, then who loses?

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  • I would say related, the other question (and answer) seems to focus more on risk.
    – Uwat
    Feb 14, 2012 at 19:54
  • Perhaps, but my answer there offers a mathematical explanation as to why leverged ETFs fail long term.
    – JTP - Apologise to Monica ♦
    Feb 15, 2012 at 2:54
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    The SEC would like to chime in with a real-world example - sec.gov/investor/pubs/leveragedetfs-alert.htm - "Between December 1, 2008, and April 30, 2009, a particular index gained 2 percent. However, a leveraged ETF seeking to deliver twice that index's daily return fell by 6 percent—and an inverse ETF seeking to deliver twice the inverse of the index's daily return fell by 25 percent."
    – user296
    Feb 17, 2012 at 6:37
  • Can I ask what "beat the market" means?
    – gef05
    Feb 18, 2012 at 17:02
  • @gef05 - you can, and it would be a valid standalone question! But to "beat the market" means to earn a better return than "the market" at large - typically represented by the S&P500 index. An S&P500 index fund is a good "where to invest if you don't actually have any specific good ideas about where to invest" and is an important baseline: if you are doing something more risky than investing in the market (e.g. in individual stocks, or real estate), you should expect higher returns - or, why take those risks? It is notoriously difficult to consistently beat the market.
    – user296
    Feb 22, 2012 at 1:26

5 Answers 5

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If the index goes up every single day during your investment, you would indeed be better off with 2x ETFs, assuming no tracking errors.

However, this is basically never the case. Indexes fluctuate up and down. And the problem is, with these sorts of ETFs, you double your win on the upside but your downside is more than double. If an index goes up 10% one day and down 10% the next, you lose 1% of the value of your investment (1.1 * 0.9). If you are using 2x ETFs, you lose 4% of the value of your investment (1.2 * 0.8), not 2%. If you are using 3x ETFs, you lose 9% of the value of your investment (1.3 * 0.7), not 3%.

So, if the index will continue to rise during your holding period, yes, you are better off with these 2x or 3x ETFs. If the index falls on some days, but rises most other days, the added downside is all but certain to make you lose money even though the stock trends upward. That's why these ETFs are designed for single-day bets. Over the long-term, the volatility of the stock market, combined with your exponentially increased downside, guarantees you will lose money.

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  • I could also make the following, amazingly similar argument: What if there were 0.5X ETFs (perhaps there are, I don't know)? If the 1X ETF earns 10% one day, loses 10% the other day, you lose 1% of the value. But the 0.5X ETF does not lose 0.5% of the value, but rather 0.25% of the value. Why, then, would 1X be the "magical" number?
    – Uwat
    Feb 15, 2012 at 18:04
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    I did not say that a 2X ETF fails to beat a 1X ETF. I explicitly state that if the index goes up every single say, you would indeed be better off with a 2X ETF. Similarly, if the index goes down every single day, you are better off with a 1X ETF. What is often counter-intuitive is that, if there's a lot of volatility in the index, a 2X ETF will almost always come out worse than a 1X ETF, for mathematical reasons.
    – ChrisInEdmonton
    Feb 15, 2012 at 18:58
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    To take your example, a 0.5X ETF will do worse than a 1X ETF if the index goes up every single day, better if the index goes down every single day. A 0X ETF would do much worse than a 1X ETF on rises, much better on drops. But you'll probably never see an ETF offered below 1X; the offering company is taking too much risk for the volatility. An index that started at 100, went up 50% to 150, then down 33% to return to 100 would mean that a 0.5X ETF ended up paying out 4.
    – ChrisInEdmonton
    Feb 15, 2012 at 19:05
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    No, a 2X ETF will return worse results on average, given AVERAGE index volatility. Given a monotonically increasing index, a 2X ETF will return better results. You will most certainly be able to find periods of time WITH VOLATILITY where a 2X ETF will win out, though perhaps not by as much as you think, but over the long haul, it does not. Try plugging in numbers in your spreadsheet. You CAN make money. You CAN make more money. Even with volatility. But over the long-run, it is statistically improbable, given average volatility.
    – ChrisInEdmonton
    Feb 15, 2012 at 19:33
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    Uwat - sorry, it's intuitive for me. I know that (x+y)(x-y)=x^2-y^2 so the idea that a number of 2X gains and losses just become larger losses stands to reason.
    – JTP - Apologise to Monica ♦
    Feb 16, 2012 at 5:52
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You miss the step where the return being doubled is daily.

Consider you invested $100 today, went up 10%, and tomorrow you went down 10%. Third day market went up 1.01% and without leverage - got even.

Here's the calculation for you:

day - start - end

1 $100 $120 - +10% doubled

2 $120 $96 - -10% doubled

3 $96 $97.94 - +1.01% doubled

So in fact you're in $2.06 loss, while without leveraging you would break even. That means that if the trend is generally positive, but volatile - you'll end up barely breaking even while the non-leveraged investment would make profits. That's what the quote means.

edit to summarize the long and fruitless discussion in the comments:

The reason that the leveraged ETF's are very good for day-trading is exactly the same reason why they are bad for continuous investment. You should buy them when there's a reasonable expectation for the market to immediately go in the direction you expect. If for whatever reason you believe the markets will plunge, or soar, tomorrow - you should buy a leveraged ETF, ride the plunge, and sell it in the end of the day. But you asked the question about volatile markets, not markets going in one direction. There - you lose.

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  • Thanks for your answer. I understand that rates are doubled on a daily basis. However, consider the following: 1. If you were to invest for only one day, would you think it would be profitable to invest in a leveraged ETF (assuming its expectation is positive)? 2. If you answered yes to (1), then after selling the stock at day n, why not buy it again at day n+1? 3. If you should buy it at day n+1 as in (2), you might as well keep the stock forever. Also, your answer presents only an hypothetical situation -- it does not in any way prove that returns would be lower or negative.
    – Uwat
    Feb 14, 2012 at 19:51
  • littleadv is correct. Take a look at the charts of any leveraged ETF. You'll find that over the long term, they all decay. If the market has an extended swing in one direction, then you can realize significant profits. However, high return always comes with high risk. Even according to the companies that sell them, these products are meant for sophisticated (day-)traders only.
    – Jason R
    Feb 14, 2012 at 19:54
  • @Uwat if I were able to definitely predict index behaviors, I wouldn't be telling it to you, rest assured:-) Going up one day, and down the same percentage the next day is pretty frequent from my observations, and that is why leveraged ETF's are dangerous.
    – littleadv
    Feb 14, 2012 at 19:56
  • @Uwat: I would also beware applying principles of statistics such as expectations too freely; while your assertion may be correct over a very large ensemble of daily returns for a given index, there is a very practical saying: "the market can stay irrational longer than I can stay solvent." Your statistical analysis wouldn't help you if you invested in a double-long fund in early September 2008 (although there were much fewer back then). True, there is potential for high reward, but also very high risk with such an approach.
    – Jason R
    Feb 14, 2012 at 19:56
  • I understand that such a strategy is excessively risky. And even if it were true that say, the probability of a leveraged ETF going down over a year was 75%, this would not necessarily indicate that the expectation would be lower than the non leveraged ETF (which could be assumed to go down over a year 50% of the time) since those low returns might be compensated by very high returns the other 25% times.
    – Uwat
    Feb 14, 2012 at 20:05
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Here is a simple example of how daily leverage fails, when applied over periods longer than a day. It is specifically adjusted to be more extreme than the actual market so you can see the effects more readily.

You buy a daily leveraged fund and the index is at 1000. Suddenly the market goes crazy, and goes up to 2000 - a 100% gain! Because you have a 2x ETF, you will find your return to be somewhere near 200% (if the ETF did its job). Then tomorrow it goes back to normal and falls back down to 1000. This is a fall of 50%. If your ETF did its job, you should find your loss is somewhere near twice that: 100%. You have wiped out all your money. Forever. You lose. :)

The stock market does not, in practice, make jumps that huge in a single day. But it does go up and down, not just up, and if you're doing a daily leveraged ETF, your money will be gradually eroded. It doesn't matter whether it's 2x leveraged or 8x leveraged or inverse (-1x) or anything else. Do the math, get some historical data, run some simulations.

You're right that it is possible to beat the market using a 2x ETF, in the short run. But the longer you hold the stock, the more ups and downs you experience along the way, and the more opportunity your money has to decay.

If you really want to double your exposure to the market over the intermediate term, borrow the money yourself. This is why they invented the margin account: Your broker will essentially give you a loan using your existing portfolio as collateral. You can then invest the borrowed money, increasing your exposure even more. Alternatively, if you have existing assets like, say, a house, you can take out a mortgage on it and invest the proceeds. (This isn't necessarily a good idea, but it's not really worse than a margin account; investing with borrowed money is investing with borrowed money, and you might get a better interest rate. Actually, a lot of rich people who could pay off their mortgages don't, and invest the money instead, and keep the tax deduction for mortgage interest. But I digress.) Remember that assets shrink; liabilities (loans) never shrink.

If you really want to double your return over the long term, invest twice as much money.

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  • +1 for discussing the margin account, a much more appropriate (though still risky) way to double your upside.
    – ChrisInEdmonton
    Feb 17, 2012 at 14:23
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NO.

All the leveraged ETFs are designed to multiply the performance of the underlying asset FOR THAT DAY, read the prospectus. Their price is adjusted at the end of the day to reflect what is called a NAV unit. Basically, they know that their price is subject to fluctuations due to supply and demand throughout the day - simply because they trade in a quote driven system. But the price is automatically corrected at the end of the day regardless.

In practice though, all sorts of crazy things happen with leveraged ETFs that will simply make them more and more unfavorable to hold long term, the longer you look at it.

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See http://blogs.reuters.com/felix-salmon/2011/04/30/why-the-sec-should-look-at-levered-etfs/?dlvrit=60132, http://symmetricinfo.org/2011/04/are-investors-in-levered-short-treasury-etfs-a-disaster-waiting-to-happen-pt1/, and the articles linked from it:

The issue with holding a levered ETF past 1 day is that investors expose themselves to path dependency in the underlying....

The reason for the difference in payouts comes from the fact that the manager of the levered ETF promises you a multiple of the daily returns of the underlying. To be able to promise you these daily returns, the ETF manager has to buy/sell some of the underlying every day to position himself to have a constant leverage ratio the next day. The short video below explains this process in detail for a 2x long ETF, but the same result holds for a 2x short ETF: the manager has to buy more of the underlying on a day when the underlying increases in value and sell more of the underlying when the underlying goes down in value .

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