No one really knows what the market is going to do tomorrow. If they did, there would be many more billionaires than there are former day traders. The fact of the matter is that day-to-day movements on the market can be dramatic, illogical, and come seemingly out of nowhere. That's why, at The Motley Foo,l we focus our attention on stocks you can buy and hold for years.
Today, I'd like to caution you about one of the most dangerous investment instruments on the market: leveraged ETFs. It isn't that leveraged ETFs don't have a place -- for example, they can play a role for traders trying to hedge against something -- but they never, ever belong in someone's long-term portfolio. They're all destined to underperform the market -- and here's why.
Daily compounding is a race to the bottom
What most people don't understand is that most leveraged ETFs are leveraged to the daily moves of the market. So, over time, the volatility of the market will eat away potential returns.
Take the example below of triple daily levered bull and bear ETFs that follow an index. The index closed Friday at 100, and each ETF also closed Friday at $100. Over the course of the week, the index gyrates around, and closes the following Friday at the exact same level. Meanwhile, the ETFs triple the daily moves of the index on the bull side, and are negative the daily move's percentage on the bear side.
|
Index |
Daily Percentage Move |
Theoretical 3X Bull ETF Price |
Theoretical 3X Bear ETF Price | |
|---|---|---|---|---|
|
Monday |
110 |
10% |
$130.00 |
$70.00 |
|
Tuesday |
90 |
(18.2%) |
$59.09 |
$108.18 |
|
Wednesday |
92 |
2.2% |
$63.03 |
$100.97 |
|
Thursday |
95 |
3.3% |
$69.20 |
$91.09 |
|
Friday |
100 |
5.3% |
$80.12 |
$76.71 |
Notice what the daily leverage does to returns of the leveraged ETFs. Instead of ending at the same level as a week before, they're both significantly lower after a week of volatile trading.
This phenomenon takes place in any ETF that tracks the daily performance of an index. Given enough time, they're all destined to move toward zero.
Killing long-term returns
The dangers of these instruments can be seen long term in ETFs that follow the Dow Jones Industrial Average (^DJI 0.06%) and the S&P 500 (^GSPC -0.22%). ProShares Ultra Dow30 (DDM 0.14%) is the 2X bull ETF that follows the Dow, and ProShares UltraShort Dow30 (DXD -0.09%) is the 2X short version. You can see that since 2006, they've both vastly underperformed the Dow itself, even though the Dow is up 66.9%.
DXD Total Return Price data by YCharts
The same goes for ProShares Ultra S&P 500 (SSO -0.47%) and ProShares UltraShort S&P 500, which have both underperformed the S&P 500.
SDS Total Return Price data by YCharts
Stick to long-term investing
Whether you think a leveraged ETF is a shortcut to quick gains, or you're trading it on a daily basis, it's important to understand how each ETF works, and what its disadvantages are. No matter what, leveraged ETFs aren't meant to be investments you buy and hold for years on end. I've shown above that that's a way to underperform the market no matter which side you're betting on.
