Need advice on Leveraged ETFs
Alright, so I recently began investing and initially had all my money in SPY as over the years passive investing has been pounded into my head. I still believe that for my goals passive investing is the best way to go.
However recently I learned about leveraged ETFs such as SPXL, which aims for 3x daily return of the S&P500 and TQQQ which aims for 3x daily returns in select NASDAQ-listed firms.
My question is, if you want to passively invest, and believe that funds tracking the S&P500 will continue to grow over time, why wouldn’t you just invest in a leveraged ETF like SPXL?
It seems the consensus is that you don’t because if the market moves up and down repeatedly you end up losing more money than you would if you just held a standard ETF. I saw someone go as far as to say you should never consider holding a leveraged ETF for more than one day.
Wouldn’t you still end up over time? What are your thoughts on this?
Weird leveraged ETF question came up while interviewing, can someone help? (Originally Posted: 08/09/2015)
I was in an interview for an internship and the question was "if one were to invest in a double leveraged (non inverse) fund what would happen if the base security were to drop 50% in a day or 51% in a day?" I said that it is very unlikely for a security that has its own leveraged fund to move with such volatility yada yada but the question threw me off and i didnt answer it well. ive thought about it for a few days now but i am still not really sure what would happen. could anyone shed some light on what the outcome would be if it were to happen?
The general answer is that the LETF goes to $0 in that scenario. However, if you think about the business case from the fund provider, this is an obvious problem. They make money based on the fund's fee and that fee can't be assessed if the assets are entirely wiped out. If you look at the prospectus' from most LETF providers (Proshares and Direxion have several to compare/contrast) they will specifically state a single day cut-off for a large underlying move. This isn't always the case (it appears that some LETF's will actually go to $0 in a single day if the underlying index move is large enough) but seems to be the general rule and overall fairly reasonable.
It's also worth mentioning that several of the LETFs maintain their daily exposure via several different swap mechanisms and these instruments can create unexpected payoffs during extreme events largely due to legal structure or credit worthiness of the issuer.
$0
By simple definition, your P&L in a security that is 2x levered (200%), will be 2x the move in the underlying. So, if you have 100k, and you use that to buy 100k of an 2x ETF (essentially taking a position of 200k in the underlying), then your P&L should correspondingly move as though you have a position of 200k of the underlying. So, if that 200k position (which you funded with 100k) moves 50% (50% of 200k = 100k), then you have either
a) doubled you initial 100k investment b) lost it all
if you've lost it all, and the move is actually 51%, and the leveraged instrument is futures, then te fund owes the exchange the additional 1% of 200k. I imagine for an ETF, the prospectus defines that the fund cannot go negative in this case, and the investment will just be worth zero. I'm not sure how leveraged ETF's handle that particular scenario. Typically, the ETF is then worth zero, investors should get zero, and the manager of the ETF attempts to flatten out the fund. Usually the administrator will eat any additional losses, but they should be minimal, because ETF's rebalance their exposure on the way down.
However, there is a catch. These leveraged ETFs are designed to always be the leveraged amount of the underlying (in this case, 2x), and this leverage is created using derivatives (sometimes futures, usually swaps). The devil is in the details here. In order to create that leverage, ETF funds will enter into a swap with an investment bank, and rebalance that swap on a daily basis, so as to maintain the 2x leverage.
So, for a long 2x ETF, on days when the underlying rallies, the ETF will need to use the mark-to-market P&L to buy more underlying (swap) at the end of the day to get "more long" to keep the 2x leverage (otherwise, the leverage drops). This works fine until the underlying starts going the other way. When a long 2x ETF underlying sells off, the ETF will need to sell the underlying, also to keep the leverage ratio at 2x. When the underlying is volatile and not trending, these rebalances end up reducing the total value in the fund. Think about it this way....you are buying high on the way up, and you are selling low on the way down (the rebalance takes place at the end of the day, after the move has taken place).
So if a 100k 2x ETF underlying (200k) goes up 10% (20k), the ETF is now worth 120k (2x exposure). The ETF will need to buy 20k of additional underlying (to keep the 2x leverage ratio). If the Underlying falls back the same 20k the next day, the ETF will have fallen in value by 10% of 220k = 22k. So, the underlying is unch after 2 days, but the ETF position is (+20k followed by -22k) = -2k (strictly because of daily rebalancing).
If there was some type of profit taking or risk management strategy in place, maybe this would be ok, but that is not the case for a leveraged ETF Almost by definition, over time, a leverages ETF will bleed money (unless the underlying is a one-way freight train...which of course does not exist) because they are always buying after an up-move...and always selling after a down move. This is why ETFs are described as an ok trading vehicle, but a horrible long term investing vehicle.
While its non-common for ETFs to have these catastrophic losses, it absolutely does happen. Since the management company makes $$ from the management fee, in the event of catastrophic loss, the fees provide a buffer for the fund to absorb the bit of loss before the final unwind.
Years later... but bumping.
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