Leveraged ETFs -- like those that aim to double or triple a stock index's returns -- might seem like a great way to boost your investment returns. But it might come as a surprise that more often than not, the exact opposite happens.
In this Nov. 17 Fool Live video clip, Fool.com contributors Matt Frankel, CFP, and Jason Hall discuss how leveraged ETFs work, and more importantly, why they don't work how many investors think they do.
Matt Frankel: I said we were going to get to leveraged ETFs, so let's really quickly just give a warning about them. We could just say don't buy leveraged ETFs and just call it a day here.
Jason Hall: I think the why is important. I think most people just don't understand that most leveraged ETFs, they reset. They might reset every day, they might reset monthly. Go ahead.
Matt Frankel: A leveraged ETF might be designed to double the S&P's return. If the S&P goes up by three percent, then this one would go up by six percent. A lot of people think that that's a great way to get good long-term returns because, over the long term, the S&P tends to go up 10 percent or so on average per year. So why not use a leveraged ETF to get an average of 20 percent a year? Wouldn't it be great if it worked that way?
Jason Hall: Oh, buddy.
Matt Frankel: But leveraged ETFs, like Jason said, they tend to reset and they're designed more specifically to match a certain amount of the daily return of their underlying index. If the S&P goes up by two percent today, it would be designed to go up by four percent today. If it went down by three percent tomorrow, it will go down by six percent tomorrow. It's not designed to mimic the long-term returns. I could bore you with the mathematics lesson right now but the mathematics are really against that daily magnification.
Jason Hall: These are trading mechanisms.
Matt Frankel: Let me just give you a quick mathematical overview why this works. Let's say that your favorite stock reported terrible earnings and went down by 50 percent today. What percentage does it need to go up by for you to get back to even?
Jason Hall: A hundred percent.
Matt Frankel: A hundred percent. So to make up a 50 percent decline, you would need 100 percent move in the opposite direction. Now, imagine doing these "decline, having to make up more ground to get back to even" moves, but every day, like a leveraged ETF does. That's a simple explanation of why the mathematics are not in your favor.
Jason Hall: They're day trading with margin.
Matt Frankel: Right. They're day trading with margin, essentially. You need to get an even higher upside move to make up for every downside move, and over time, this really eats away. Find a triple leveraged S&P 500 ETF and look at its returns over the past year. It's not three times the total return of the S&P, I can pretty much promise you that. So these are bad ways to try to make money for a long term. Same with inverse ETF, which essentially is a short. It's a way to short without shorting, it's shorting the daily moves of an index.
Jason Hall: There you go. The Direxion Daily S&P 500 Bull 3X ETF (NYSEMKT: SPXL) year-to-date is up 7.3 percent over the past year, over the past 12 months. So it's up 7.9 percent total returns. I guess there's some mechanism for dividend delivery there. S&P 500 is up 18 percent.
Matt Frankel: Right. So the tripled-leveraged bullish ETF they'd invested in the S&P is up about one-third of the amount as just the S&P itself.
Jason Hall: Yeah. The beginning of the year, the market's up 14 percent and that tripled-leveraged bull ETF is down 2.7 percent.
Matt Frankel: It's because of these giant downside moves you saw in March and that mathematical disadvantage that I was just talking about, the market goes down by 50 percent, you need a 100 percent upside move to get back to even. The pandemic crash in March just really took out of some of these leveraged ETFs. But they're bad ways to make money long term.