Concerned about an AI bubble? Sign up for The Daily Upside for smart and actionable market news, built for investors.
For some investors, financial planning now means holding a leveraged ETF until Thursday.
ETFs that offer two- and three-times the daily market exposure to underlying investments, or are structured to bet against those investments, have been gaining popularity across the broader investing universe. According to VettaFi, there are now approximately 770 leveraged and inverse ETFs on the market in the United States. When it comes to ramping up portfolio performance through exchange-traded funds that leverage exposure to an underlying index or single stock, however, most financial advisors are waving the caution flag.
“Issuers are launching products tied to whichever single stock or sector happens to be capturing the zeitgeist, whether that’s artificial intelligence hardware, crypto-adjacent equities or even major IPOs,” said Kirsten Chang, VettaFi senior industry analyst. “The massive shift here isn’t just that the category is growing, it’s how it’s expanding.”
Sign up for The Daily Upside at no cost for premium analysis on all your favorite stocks.
READ ALSO: Wellington’s $1.9B Deal to Buy Hartford Funds and Robinhood’s New AI Trader Is Raising Red Flags for Advisors
Spin the Wheel
Historically, leveraged ETFs were tied to broad market indexes like the S&P 500 or Nasdaq 100, but the industry is expanding rapidly and the real explosive growth is in “hyper-targeted” ETFs. Citing the growing appeal among active traders, Chang explained that “the market has essentially evolved from a macro hedging tool into a highly granular casino for high-conviction daily stock traders.”
While market sizing in this category is a constantly moving target, a half-dozen popular leveraged ETFs ramp up exposure to some technology and broad market indexes and combine for more than $90 billion in assets, according to the data. In terms of trading volume, two ETFs that leverage up the tech sector — the ProShares UltraPro QQQ (TQQQ) and the Direxion Daily Semiconductor Bull 3X Shares (SOXL) — “are among the most heavily traded securities on the planet on a daily basis, occasionally pulling in higher daily trading volumes than the actual tech giants they track,” Chang said.
It’s against that backdrop that financial advisors are navigating the flood of new leveraged and inverse ETFs while trying to keep the focus on longer-term investing, as opposed to the more aggressive practice of day trading. “I don’t like them at all because I don’t think they work that well over the long term,” said Chuck Failla, founder and chief executive of Sovereign Financial Group. “You’re basically making a short-term bet that something is going to happen, and I wouldn’t make a short-term bet on anything,” he added. “It’s too much like gambling for me.”
Short-Term Memory
As designed, this specific category of ETF is the definition of short-term trading. Because the leveraged or inverse exposure in the funds resets daily, they are betting on short-term trends and any sudden reversal in direction can result in punishing consequences for the unwitting investor. “Generally speaking, leveraged funds have performed fairly well against their daily return mandates; however, many investors think of ETFs as a strategic, longer-term holding, which is not what leveraged ETFs are designed for,” said Don Bennyhoff, founder of Bennyhoff & Co.
“These ETFs aren’t suitable for most clients or client circumstances, as they are unlike the funds or ETFs that clients are commonly familiar with,” he added. “They have unique nuances that should be understood before purchase, not realized afterwards.”
The Daily Reset
Aside from reluctance to steer investors toward short-term trading vehicles over longer-term investments, advisors don’t believe most casual investors are completely fluent in the way leveraged and inverse ETFs respond to market conditions when held for more than a few days.
Over one trading day, an ETF that is offering twice-leveraged exposure to an underlying index will produce double the return for that day, minus fees and expenses. But, because the ETFs reset daily, over periods longer than a day, the ETF’s performance will diverge from the underlying index due to the compounding effect of daily rebalancing.
For example, if an unleveraged index drops 10% one day and gains 11% the next day, it is back to even. However, an ETF offering 2X leverage to that same underlying index will finish lower than where it started because the math of daily compounding works against it in volatile, sideways markets. “We think it is prudent for advisors and clients to understand and acknowledge the range of possible outcomes when using leveraged ETFs as opposed to simply assuming, as is suggested in the name, that they will always provide some amplified return of their underlying,” said Joel Sues, portfolio manager at Burney Wealth Management.
Electric Vehicle Volatility
Sues cites Tesla stock and an ETF designed to leverage Tesla stock as a classic example of how investors might get tripped up. Comparing the performance of the Tesla (TSLA) stock with that of the Direxion Daily TSLA Bull 2X Shares (TSLL), an ETF offering 2X leverage on Tesla shares, presents eye-opening results. Over the trailing 12 months, Tesla stock is up more than 23%, which compares to a 1.8% gain for TSLL over the same period. This year through the end of May, when Tesla stock lost 5.8%, TSLL fell by 23%.
“Most 2X-leveraged ETFs provide more absolute performance with significantly more volatility risk on a daily, weekly or monthly basis, and most advisors I’ve spoken to do not use them as they are considered unnecessarily risky,” said Cyrus Amini, chief investment officer at Hyphen Wealth Management. “The leverage may lead to higher returns, but the large sudden price swings can create client panic,” he said. “Additionally, the use of leveraged strategies creates much more compliance risk for advisors relative to normal strategies.”
High Risk, High Reward. Chang of VettaFi said regulators have started clamping down on ETF leverage by limiting leverage to two times the underlying index or stock. But any ETFs offering three times leverage prior to last year have been grandfathered in by the Securities and Exchange Commission.
“What is changing here is that the regulatory line has been drawn,” Chang said. “These ETFs are primarily built for sophisticated day traders, hedge funds and algorithmic trading desks looking to express a very short-term view without having to manage an actual margin account or trade complex options.” Unfortunately, there is also a fair amount of retail “lottery ticket buyers” who use them during rallies, often without fully understanding how they work, especially the daily reset, and can hold them for months or longer.
Failla of Sovereign Financial Group is also in the camp that argues levered and inverse ETFs are making it too easy for some investors to get in over their head. “There’s a better way to do this; you could more efficiently go into the options markets for leverage or short exposure,” he said. “These ETFs make it easy for less sophisticated investors to make these types of bets.”
This post first appeared on The Daily Upside. To receive financial advisor news, market insights, and practice management essentials, subscribe to our free Advisor Upside newsletter.