Are Leveraged ETFs Driving the Stock Market Rally?

Stock markets were broadly higher on Monday, reversing course from Friday's swoon as it became apparent that President Trump was responding well to treatment for his COVID-19 infection. Gains for major market benchmarks were substantial, with the Dow Jones Industrial Average (^DJI -0.82%) and S&P 500 (^GSPC -0.41%) picking up almost 2% on the day.

Today's stock market

Data source: Yahoo! Finance.

Many investors look for the quickest way they can find to get rich. For them, using leveraged ETFs can be an easy way to try to multiply their winnings when they make correct calls. However, those who don't fully understand leveraged ETFs don't always appreciate the danger that they pose. Below, we'll look at how leveraged ETFs have gotten more popular and what risks you need to be aware of.

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Can you really triple your returns?

Leveraged ETFs are designed to produce daily returns that are multiples of the return of certain market benchmarks. They typically do so through the use of derivatives.

The key word above is "daily." When you look at most leveraged ETFs, they do a great job of doing exactly what they claim to offer: tracking the one-day performance of an index.

Different levels of leverage are available from different ETFs. Some are designed to double the return of an index, while others are more aggressive and offer triple the returns. You can generally get inverse leveraged ETFs as well, whose share prices rise when the market falls and vice versa.

Leveraged ETFs have gotten increasingly popular lately. For instance, the ProShares Ultra Pro QQQ (TQQQ -1.55%), which offers three times the daily return of the Nasdaq 100 Index, traded nearly as many shares today as the regular ETF Invesco QQQ Trust (QQQ -0.47%). The inverse 3x ETF ProShares Ultrapro Short QQQ (SQQQ 1.40%) traded more shares, although its share price is well below the QQQ Trust's.

When leveraged ETFs fall short

The emphasis on daily returns makes leveraged ETFs not as effective for investors seeking enhanced exposure to the stock market over the longer term. The investments that these leveraged ETFs use aren't designed for longer periods, so their effectiveness is mixed at best.

For instance, when you look at 2020 to date, you'll see that the Invesco QQQ Trust is up about 32%. Some might expect a triple-exposed leveraged ETF like ProShares UltraPro QQQ to be up triple that amount. Instead, it's up 54% -- an impressive outperformance but just 1.7 times the return of the QQQ. Meanwhile, the UltraPro Short QQQ is down almost 80% -- again, not quite double the inverse but still a painful loss.

Sometimes, the outcome can make everyone a loser. Over the past month, with wild oscillations in the market, the QQQ is down 1%. The UltraPro long 3x leveraged ETF is down 5%, which is understandable and not too far from the theoretically correct value. However, the UltraPro Short QQQ ETF is also down, falling more than 2%.

Let the investor beware

It's true that leveraged ETFs can greatly enhance your returns when the stock market  moves in one direction for a sustained period of time. From March to August, for instance, the UltraPro QQQ actually did better than triple the returns of the Nasdaq 100.

Over the long run, though, leveraged ETFs have almost always fallen short of the mark. That makes them dangerous tools for those who aren't aware of their shortcomings. If more people are using leveraged ETFs without fully understanding them, then it could bode well for the health of the current bull market.