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I read everywhere online that leveraged ETFs shouldn't be bought for the long term. Here is a comparison between TECL (Technology Bull 3x) and the S&P 500. As you can see, the CAGR is 32% in the last 7 years.

100,000 invested in S&P 500 in 2011 would be worth 268,000

100,000 invested in TECL in 2011 would be worth 1,510,000

While the first return is not life changing, the second one is.

So my question is, why does everyone say to stay away from leverage ETFs? Is there a flaw in the backtest ? Thank you

Screenshot from portfolio visualizer

  • They're great in a strong bull market, but what do you think would happen in a recession or depression? – Kevin Sep 7 '18 at 0:21
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    They could easily been wiped out if the market corrects too much, right ? – Emil Lazzaroni Sep 7 '18 at 1:01
  • Correct. The biggest S&P drop in a day was over 20%, and for the DJIA it was 23.5% can you imagine losing 60%–75% of your investment in a single day? And the amplified drawdown in a prolonged bear stretch or even just a volatile period can seriously hurt. – Kevin Sep 7 '18 at 1:07
  • That said, I've run the historical numbers and it can be a viable part of a balanced portfolio IF you understand the return won't be 3x (more like 1.25–1.5x), and you can control your emotions and not panic when (not if) the market drops and you see big negative numbers. – Kevin Sep 7 '18 at 1:11
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    I think is something to approach more like crypto, a gamble :) – Emil Lazzaroni Sep 7 '18 at 11:54
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First you have to consider a basic mathematical fact. A 5% loss is a larger loss than the following 5% gain is a gain. Let me show you with an example.

Say you have $1000 a 5% loss is a 50 dollar loss un-leveraged. That brings you down to $950.

(1000-950)/1000 = 0.05 -> 5%

To get back to where you started how much do you have to gain? If you said 5% you would be wrong.

(1000-950)/950 = =0.0526 -> 5.26%

This problem becomes exponentially worse when you leverage your gains, because you also leverage your losses. As other answers have mentioned.

The reason TECL has been such an amazing run is because there has not been a major loss yet. There will be one sooner or later. When? No one knows, anyone who says they do is a liar. When that loss comes TECL will almost certainly become less profitable. In times when everything is going good triple leveraged is great... until things don't go well, which always happens sooner or later.

  • Yep i know that mathematic fact, thank you so much :) – Emil Lazzaroni Sep 7 '18 at 10:51
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TECL performed extraordinarily well because it was a sector the did well and because your time frame does not include any severe market corrections. Unfortunately, TECL only exists since December of 2008 so it can't be used for such a comparison. So let's consider the DJIA.

From the end of the GFC (3/09/08) until now, DIA returned 397% whereas DDM (2X DJIA ETF) returned 1,666% for better than 4X return.

However, if the starting date used is 12/31/07 at the beginning of the GFC then DIA returned 158% while DDM returned 281%, less than 2X. So why the huge discrepancy (4X versus 2X)?

For the GFC (1/01/08 to 3/09/09), DIA returned -49% while DDM returned -79%. If a leveraged ETF loses 4/5 of its value, the road back is much slower because they can only leverage that 20% of remaining value. IOW, the DIA required a 100% rise to break even but the DDM required a 400% rise to do the same.

Another issue for much shorter holding periods is the P&L due beta slippage but I'm going to pass on that explanation since your question dealt with a 7 year long term hold.

  • Thank you so much Bob. So in your opinion, after the next financial crisis, could be a good moment to invest some money on a leveraged one ? – Emil Lazzaroni Sep 7 '18 at 0:59
  • @EmilLazzaroni the problem is "after." How do you tell when it's bottomed out? – Kevin Sep 7 '18 at 1:14
  • It's always a good time to invest after a financial crisis but as Kevin asked, how do you know where the bottom is? You'll only know that in hindsight. If a long term investor, you might be best served by averaging in. As for what I'd do, I'd be short and I would only consider leveraged ETFs for short term trading. When transitioning back to long, I'd be hedging to avoid being seriously wrong and taking a big hit. A lot of that has to do with being older and it being more important to keep what I have than making a lot more of it. I appreciate the latter but I won't accept the former – Bob Baerker Sep 7 '18 at 1:26
  • You can use the moving average to see where the trend is going. Longer the moving average, more reliable it is, but more later on you will enter :) – Emil Lazzaroni Sep 7 '18 at 10:10
  • The longer the MA, the less noise and the fewer the number of whipsaws. In return for that benefit, your trade execution will be late in and late out (Lag). If you shorten the MA, you'll have more timely entry and exits but you'll incur a lot more whipsaws. IOW, MA-s work in trending market. The only way to know which MA will work best is hindsight. – Bob Baerker Sep 7 '18 at 12:06
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The problem with your math isn’t the math; it’s the person. In 2008 I bought some SSO (double S&P ETF). The current price is about 3x what I paid, but I didn’t keep it- I bailed when the market tanked because it looked like it might actually go to zero. If your psyche is typical, you would likely have done the same.

  • I'm thinking like you should invest in those things more like gambling than thinking they are investments for the long term maybe – Emil Lazzaroni Sep 7 '18 at 10:50
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Leveraged funds offer more return, yes. Also more risk. But actually not just risk of losing three times as much - there are some things people often overlook:

  • If the S&P trades range bound, without going up or down overall, but making many small up/down movements, then a normal S&P fund will break even. The leveraged will lose. The reasons for this are boring and have to do with how leveraged funds work behind the scenes. But you can see this for yourself by comparing a portfolio of 1:1 bull and bear (inverse) etfs (which will be neutral) to 3x bull and bear etfs (which will decline).
  • If the S&P goes down more than 33% (happened many times) you can lose more money than you had in your account.

Generally, holding a 3x fund, especially for S&P, is not really that bad assuming it actually does go up. You just have to watch out for the two above problems and also keep in mind that draw downs will be 3x as bad too.

  • "If the S&P goes down more than 33% (happened many times)" Not in one day it hasn't; the biggest drops were 20, 12, and 10%. The max drawdown on a calculated S&P fund (from before they were a thing) is 87.3% (2x) and 97.7 (3x). The actual S&P drawdown in the same period was 56.8%. Not for the faint of heart, certainly, but never bankrupt. – Kevin Sep 7 '18 at 2:42
  • @Kevin I never said it has to drop in one day. That really has little bearing on what is being discussed here, namely holding leveraged funds long term. – Money Ann Sep 7 '18 at 7:01
  • @Kevin - What does dropping 33% in one day have to do with this discussion? The market can drop slowly and an investor is likely to hang in there and then all of a sudden, the bottom falls out (for example, see 1987). – Bob Baerker Sep 7 '18 at 12:16
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    @BobBaerker: Because the structure of the leveraged fund matches 3x (or -3x for bear) the daily performance of the underlying. If the underlying loses 20% 3 days in a row, it's down 49%. The leveraged loses 60% on the first day, but the second day it loses only 60% of what's left, and again the third day, 60% loss of what's left. That's a 94% loss in the leveraged ETF, not a 147% loss. – Ben Voigt Sep 9 '18 at 15:29
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    @MoneyAnn - Are you suggesting that a leveraged ETF puts a buyer at risk to owe money on a position if the market takes a high enough loss? Can you document this? I've never seen this warn on leverages products. – JoeTaxpayer Sep 30 at 2:41
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Generally nobody knows which such alternative investments will be profitable ahead of time. It’s easy to fall victim to survivorship bias - only observing the funds that succeeded and ignoring all the ones that failed. There’s also more information now about how history actually unfolded that makes investments in the past seem “obvious” to us now when in fact they were not at the time.

To answer your question about that tech index specifically - nobody knew whether the tech sector would do well or go bust. It did well, so if you pay a lower interest rate on the loan (leverage) than you make in the market, you dramatically increase your ROI. Tl;Dr: it was a risky investment that paid off. Probably worth looking at the many other risky investments in specialty sectors that lose using this method as well.

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The people saying to stay away from leveraged funds are the same people recommending to hold a very small number of funds (2-4) by picking funds that are very broad and diversified.

Leveraged funds are totally incompatible with that simple portfolio.

There are strategies that use leveraged funds, but they are not set-and-forget. You have to frequently rebalance, to prevent a 30% drop in the market (99% loss in the leveraged fund) from wiping out both the gains from the good years and also your initial investment.

If you are willing to manage holdings in a couple dozen funds (in a tax-advantaged account so the rebalancing transactions don't count as short-term capital gains), then there's nothing wrong with having one or two leveraged funds in the mix.

  • Thank you so much, i didn't think about the fact that a 30% market drop could lead to a catastrophic wipe out of the fund. I might wait the next financial crisis before buying a 3x bull leveraged, but I'm surely gonna try it out. Thank you – Emil Lazzaroni Sep 7 '18 at 0:56

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