Leveraged ETFs: dream returns of over 100% or speculative bet with total risk of loss?

In the last article, we looked at Lombard loans. In this article, we’ll look at leveraged ETFs, another way to boost your portfolio’s returns. You’ll find out how these niche ETFs work, which risks you should be particularly aware of and when you have the best chance of achieving dream returns.

What is a leveraged ETF?

Leveraged ETFs or leveraged ETFs are special synthetic ETFs that are often classified as strategy ETFs. In synthetic index replication, the corresponding ETF provider swaps the investments held by the fund for those of the index by concluding a swap transaction (total return swap, a derivative) with a third party, e.g. a major bank.

Leveraged ETFs therefore track an index like their traditional counterparts. However, its price performance is amplified by a certain factor. So if a factor of two is applied, which is common, and the corresponding non-leveraged underlying index (e.g. MSCI World or SMI) rises by 2% in one day, the leveraged ETF shoots up by 4%.

The counterpart of (long) leveraged ETFs are so-called short ETFs, which behave inversely to the underlying index. The Lyxor SMI Daily (-2x) Inverse UCITS ETF, which tracks the double-leveraged inverse performance of the SMI on a daily basis, is representative of the sparse range of short ETFs. This means that if the SMI falls by 1%, this ETF rises by 2% and vice versa.

Short ETFs are not the focus of this article. We reject them because they are highly speculative, based on market timing or falling prices, and we consider the associated risk/return ratio to be extremely unfavorable.

Modest range of leveraged ETFs

The selection of conventional ETFs has become huge and investors are spoiled for choice. (Reading tip: In the article “Best ETFs Switzerland and globally: And the Winner is…” we subjected over 1,500 ETFs to a strict, multi-stage selection process and chose 14 winning ETFs).

In contrast, the range of leveraged ETFs authorized in Switzerland is still very limited. The “Justetf” portal, for example, offers just five leveraged equity ETFs on European stock exchanges. (This portal does not take stock exchanges outside Europe into account).

But it is not only in quantitative terms that the range of leveraged ETFs still leaves something to be desired. We also see two qualitative weaknesses: Firstly, not a single product is globally diversified. And secondly, we consider the fund size to be too small – with the exception of the Amundi product. (For a better understanding, we will take a closer look at this leveraged ETF later). On the other hand, we were pleasantly surprised by the annual costs of around 0.35% (TER), which we consider to be quite moderate for such niche ETFs.

It is also striking that, despite the low fund volumes, four of the five leverage ETFs were launched more than ten years ago. True to the survivorship bias, this is probably only the tip of the “leverage ETF iceberg”. Numerous products have probably been discontinued due to a lack of market success and have therefore become “invisible”. (By the way, liquidating a fund does not mean that you will suffer total losses. Instead, you simply have to withdraw the invested funds (market value) from the fund and look for suitable alternatives.

ETFs that have collected less than CHF 100 million in fund assets in the medium term are likely to be a loss-making business for fund providers. For this reason, such ETFs are particularly likely to be discontinued sooner or later.

More choice of leveraged ETFs on US exchanges – but more expensive!

On US stock exchanges, on the other hand, leveraged ETFs have become much better established. However, even here we have not come across a single globally diversified product that tracks a leveraged MSCI World Index, for example.

The largest of these, the UltraPro QQQ from ProShares, has managed to raise a considerable fund volume of over 20 bn. USD despite a high fee of 0.98% (TER). This most popular leveraged ETF in the world is considered to be particularly high-yielding and high-risk, as it tracks the volatile US tech index Nasdaq 100 by a factor of three.

This overview from the ETF portal VettaFi provides you with the most important key data on this and other leveraged ETFs traded on US stock exchanges. It is noticeable that the product selection is clearly focused on US companies, but there are major differences within this group: Some leveraged ETFs focus on blue chips, some on small caps and others on individual sectors such as technology stocks or more product-specific ones such as semiconductor manufacturers.

This shows once again that the more an ETF covers a niche, the more attractive the offering on the US stock exchanges is compared to the European trading centers.

If you want to benefit from the wider range of ETFs traded on US exchanges, you need a platform on which these products can also be traded. In our experience, the two broker pioneers Swissquote and Interactive Brokers are particularly well positioned in this respect (see our list of recommendations).

Impressive performance

We would now like to take a closer look at the Amundi Leveraged MSCI USA Daily UCITS ETF – EUR. In terms of diversification, fund size and price, it seems to us to be the most attractive leveraged ETF traded on European stock exchanges that is authorized for Swiss investors.

According to the corresponding factsheet, the MSCI USA Leveraged 2x Daily Index underlying the leveraged ETF offers twofold exposure to the daily performance of the MSCI USA Index, which comprises around 600 leading US stocks.

It is also a synthetic ETF that complies with the European UCITS investor protection guidelines. Interesting: At least 75% is invested directly in securities. Amundi confirmed to us on request that these are special assets, which investors could access even in the event of Amundi’s bankruptcy or which would not fall into the bankruptcy estate.

Amundi recommends an investment horizon of at least 5 years, which seems plausible to us. (We do not share the view often expressed in social media that leveraged ETFs are short-term investment vehicles, especially when the underlying index is broadly diversified. Why should such leveraged ETFs be treated differently from their conventional or unleveraged counterparts in terms of investment horizon?)

As the chart above impressively shows, a positively leveraged ETF can also perform very well over a very long investment horizon of almost 14 years and clearly outperform the classic ETF. This is due to the fact that, on the one hand, share prices have risen more often than they have fallen during the period under review. (As we will see later, it is particularly important for leveraged ETFs that the majority of prices rise at the beginning). On the other hand, the USA, with its major growth-oriented tech stocks such as Apple & Co, had a particularly good run compared to the rest of the stock market world. Incidentally, the performance data has already been converted into our hard home currency CHF. In EUR or USD, the increases in value would be even higher!

Mostly better performance of the leverage ETF even with different entry times and periods

If you take different entry points and periods, this positive picture is confirmed in favor of our leverage ETF. For the most part, it performs better than the classic product from the same provider, even when significant stock market dips had to be endured in between. Only in two short-term crash scenarios did the leverage variant perform worse (see table).

Hands off short ETFs!

The opposite is true for short ETFs: they generally perform poorly, even catastrophically poorly. As its name suggests, it is much more speculative and focuses on short-term gains in bear markets (see chart and table above and chart below). Short ETFs are therefore out of the question for us.

Yield sequence for leveraged ETFs is decisive for the match

But let’s come back to leveraged ETFs. What does the performance look like if we focus on the more leisurely Europe instead of the US market, which has been performing superbly since the financial crisis? Due to a lack of choice, let’s take a look at the product Lyxor EURO STOXX 50 Daily (2x) Leveraged UCITS ETF (Acc) previously listed in the leveraged ETF overview. The underlying index tracks the 50 companies with the largest market capitalization in the eurozone.

The table shows that the majority of the outperformance also applies to the EURO STOXX leverage ETF, albeit less clearly than in the previous ETF comparison, which was based on US companies according to the MSCI USA.

In addition, thanks to the fact that the publication date was further back, we were able to look at a longer period of over 16 years (instead of around 14 previously), which leads us to an interesting insight:

If the time of entry is shortly before a severe stock market crash, as in the global financial crisis of 2008, the leveraged ETF can no longer make up for the price losses, even in the long term.

After a holding period of more than 16 years, our leveraged ETF is still massively down at around 44% as at July 26, 2023, while the traditional ETF is only a good 5% below the price gain threshold. This phenomenon is known as “volatility drag” and is combined with the risk of the return sequence. You can find out more about these risks in the next chapter.

What risks do I take with a leveraged ETF?

There is no question that leveraged ETFs are riskier than conventional ETFs. This is because leveraged ETFs offer greater opportunities for returns and these are known to be associated with more risk. You should pay particular attention to the four risks described below, which apply especially to leverage ETFs:

• Volatility drag” risk
• Yield succession risk
• Counterparty risk
• “Own nerves of steel” risk

Volatility drag” risk

This risk relates to losses caused by fluctuations. Volatility drag is the negative effect of so-called path dependency. This is due to the fact that leveraged ETFs are revalued daily.

In the following table, we use a fictitious example to show how the volatility drag constantly pushes the return down slightly when markets fluctuate.

Path dependency in leveraged ETFs: Volatility drag in fluctuating markets

Day	SMI Index (points)	Change on previous day SMI ETF	Value of investment in SMI ETF (CHF)	Change on previous day SMI Leveraged ETF (2x)	Value Investment in leveraged ETF SMI (2x)
0	10’000		1’000		1’000
1	9’800	-2%	980	-4%	960
2	10’000	2.04%	1’000	4.08%	999.17
3	9’700	-3%	970	-6.00%	939.22
4	10’000	3.09%	1’000	6.19%	997.31

The volatility drag pulls the leverage ETF down slightly: Although the index returns to its starting level of 10,000 on days 2 and 4, the leveraged ETF continuously loses some of its value. The higher and longer the fluctuations, the greater the impact of the volatility drag.

In the case of moderate fluctuations, the negative effect of volatility drag is therefore hardly noticeable. The situation is different in the event of severe stock market turbulence: If, for example, the underlying index falls by 25% on one day and then rises again by 33% to the initial value, the price of the leveraged ETF remains significantly below the initial value.

Path dependency for leveraged ETFs: Volatility drag in the event of a crash with rapid recovery

Day	SMI Index (points)	Change on previous day SMI ETF	Value of investment in SMI ETF (CHF)	Change on previous day SMI Leveraged ETF (2x)	Value Investment in leveraged ETF SMI (2x)
0	10’000		1’000		1’000
1	7’500	-25%	750	-50%	500
2	10’000	33.33%	1’000	66.67%	833.33

This unrealistic scenario illustrates the negative effect of the volatility drag on the price performance of leveraged ETFs. Although the underlying index returns to its starting level after the stock market crash, the leveraged ETF remains around 17% below it.

In the most extreme (unlikely) case, leveraged ETFs can even result in a total loss: If the underlying index were to fall by 50% in one day. This would result in a 100% loss for the leveraged ETF (2x). All shares in the ETF would therefore be worthless and would remain so even after a subsequent stock market recovery, no matter how brilliant it turned out to be.

However, the path dependency effect of leveraged ETFs is not negative per se. For example, there is no volatility drag when prices are constantly rising or falling. Leveraged ETFs actually benefit in such markets. This means that the leverage is slightly increased when prices rise and slightly reduced when prices fall (see tables below).

Path dependency with leverage ETFs: positive effects with steadily rising markets

Day	SMI Index (points)	Change on previous day SMI ETF	Value of investment in SMI ETF (CHF)	Change on previous day SMI Leveraged ETF (2x)	Value investment in leveraged ETF SMI (2x)
0	10’000		1’000		1’000
1	10’200	2%	1’020	4%	1’040
2	10’353	1.5%	1’035	3%	1’071
3	10’612	2.5%	1’061	5%	1’125
4	10’665	0.5%	1’066	1%	1’136

If prices rise steadily, this has a positive effect on the leveraged ETF. For example, the value on the 4th day rises by 13.6% instead of 13.2% compared to the initial value (2 x price increase of 6.6% of the base index).

Path dependency with leveraged ETFs: positive effects with constantly falling markets

Day	SMI Index (points)	Change compared to the previous day SMI ETF	Value of investment in SMI ETF (CHF)	Change on previous day SMI Leveraged ETF (2x)	Value Investment in leveraged ETF SMI (2x)
0	10’000		1’000		1’000
1	9’800	-2%	980	-4%	960
2	9’653	-1.5%	965	-3%	931
3	9’412	-2.5%	941	-5%	885
4	9’365	-0.5%	936	-1%	876

Falling prices are inherently bad for positively leveraged ETFs. However, regarding path dependency, a positive effect results. This is because the value of the leveraged ETF decreases by only 12.4% on day 4 compared to the initial value, instead of 12.8% (2x price losses of 6.4% of the underlying index).

Yield succession risk

This risk naturally exists with all investments, including ETFs. However, as we have seen above in the comparison of returns, this risk can have particularly serious consequences for leveraged ETFs. The leverage effect is responsible for this. Specifically, if there are sharp price corrections at the start of the investment, it is virtually impossible to make up the shortfall with a leveraged ETF, even in the longer term.

There are two simple countermeasures you can take to effectively mitigate the risk of returns:

• staggered over a longer period and
• do not invest at the highest prices or after stock market dives

For the sake of completeness, it should be mentioned here that the risk of a subsequent return is associated with equally great opportunities for you as an investor. If the stock market rises sharply at the start of the investment, leveraged ETFs will literally shoot through the roof. As we saw above in the comparison of returns, this outperformance compared to the classic ETF remains even after subsequent stock market dips.

Counterparty risk

As already mentioned, leveraged ETFs are synthetic ETFs that are based on an exchange transaction (swap) in the form of a derivative. The counterparty risk is that the swap counterparty can no longer fulfill its obligations under the swap contract. This can lead to losses for the ETF and its investors. In the case of our sample ETF from Amundi, the counterparty risk is mitigated by the choice of a financially strong swap partner (BPN Paribas) and a high proportion of real investments in securities, which represent special assets.

“Own nerves of steel” risk

This risk generally exists with all risky investments, which definitely includes shares. However, this risk is particularly pronounced with leveraged equity investments, because in this variant, the already not insignificant price fluctuations in equity investments are further amplified by the leverage.  

In other words, you should honestly answer the following question: Can I still sleep peacefully with price losses of 50% or more? If you answer this question in the affirmative, or even better, if you have already weathered severe stock market crashes in the past, then leveraged ETFs could be an interesting option for you with above-average potential returns.

Otherwise, start or stick with the good old “bread and butter ETFs”, which are less volatile and can still deliver a great return in the long term. 

In addition to these four risks, which are particularly relevant for leverage ETFs, there are also risks that apply to traditional equity ETFs, such as market and currency risks.

In which market phases is a leveraged ETF particularly suitable?

It is an obvious or mathematical fact: positively leveraged ETFs perform better than traditional ETFs when prices are rising and worse when prices are falling. Unfortunately, however, the fact is that nobody can predict future developments on the stock market.

However, the past shows that a broadly diversified equity investment increases in the long term.

If we supplement this insight with the “regression to the mean” phenomenon from statistics, according to which the return on shares and other investments always moves around the so-called mean average over a longer period of time, market phases following stock market crashes are likely to be particularly interesting entry points. (Incidentally, this also applies to leveraged investments, as we explained here in our article on Lombard loans).

In contrast, all-time highs and, in particular, prices before sharp stock market dips are particularly unfavorable entry points. As we have shown above, heavy initial losses on leveraged ETFs can hardly be recouped in the long term due to the volatility drag combined with the risk of a return sequence.

However, as bear markets can also correct significantly downwards again, we consider a staggered approach, i.e. investing in a leveraged ETF in several tranches, to be an absolute must.

What are the advantages and disadvantages of leveraged ETFs?

We want to assess the pros and cons in comparison with both classic (unleveraged) ETFs and Lombard loans or securities purchases on credit.

What leveraged alternatives are there to leveraged ETFs?

Variant 1: Lombard loan

In contrast to the sparse range of leveraged ETFs, all ETFs are generally available to you with a Lombard loan. However, you should be aware of the risks associated with a margin call and rising interest costs. You can find out more about Lombard loans in our article “Lombard loans when buying ETFs: Boosting your return on equity or playing with fire?”.

Option 2: Leverage through structured products

Structured products with leverage are complex financial products that can be used to react to a price movement in the underlying asset. Popular underlying assets are individual shares, indices, commodities and currencies. We reject structured products with leverage because, in our opinion, they are too expensive and not transparent enough. The latter is particularly evident in their opaque construction.

Conclusion on the two lever alternatives

We prefer Lombard loans to structured leverage products due to their greater transparency and freedom of choice regarding the investment to be made. Note: At the time of publication of this article, Toni had leveraged his securities portfolio using a Lombard loan from Interactive Brokers.

Our conclusion on leveraged ETFs

Our first impression of leveraged ETFs was as clear as it was negative: “Too little on offer and the little that is available is not established on the market and/or insufficiently diversified. Leveraged ETFs, no thanks!” Our initial skeptical attitude was in line with the blogger mainstream.

But when we looked more closely at performance over different periods and market phases, we became more conciliatory – especially towards this leveraged ETF from Amundi, which we examined in more detail.

Nevertheless, leveraged ETFs are only suitable for investors with strong nerves who have a medium to long-term investment horizon . This is because the fluctuations are much greater than with traditional ETFs.

Total loss unlikely

However, we consider a total loss, as we have raised in the title, to be extremely unlikely with leveraged ETFs. This is because this worst-case scenario would only occur with a double leveraged ETF in the event of a daily loss of at least 50%.

However, an investment prior to a sharp stock market correction can hardly make up for the price losses in the long term due to the volatility drag caused by fluctuations, combined with the risk of a subsequent return. We would therefore only invest in a leveraged ETF on a staggered basis and preferably in bear markets.

Dream returns possible after stock market crashes and with staggered investments

And what about the dream returns of 100% and more per year mentioned in the title? These are possible depending on the market phase, but require perfect timing, which in turn is pure luck.

But much more interesting for us as convinced buy-and-hold investors is the new insight that leveraged ETFs can perform extremely well in the long term thanks to the compound interest effect – even if not at 100% annually – provided there is no imminent bear market or even a stock market crash.

Our sample ETF, for example, achieved an impressive long-term increase in value of over 1600% over around 14 years – including several stock market dives – five times more than its conservative brother, which is based on the underlying MSCI USA index.

In addition to the impressive performance track record, the surprisingly moderate costs and attractive fund size of the ETF in question caught our eye.

Conclusion

If you have strong nerves, a longer investment horizon and do not assume that a stock market crash is imminent (of course, no one can predict this with certainty, which is why you should definitely invest in a staggered manner and preferably in bear markets), you could cover the “North America” region with the aforementioned leverage ETF in the future or – more defensively, as a trial balloon, so to speak, to gain initial experience with leverage ETFs.

Whatever you decide: Before buying a leveraged ETF, you should inform yourself thoroughly about the product, understand its specific risks and recognize the fact that leveraged ETFs always fluctuate massively more than traditional ETFs – both upwards and downwards.

And what do we do? Stefan is considering launching such a “leveraged” trial balloon at the next opportunity or when this is indicated in the course of rebalancing, while Toni still prefers the leveraged approach using a Lombard loan and does not want to further increase his already sporty risk exposure for the time being.

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Disclaimer

Transparency note: At the time of publication, Toni and Stefan are neither invested in leveraged ETFs nor do we have a business relationship with the ETF providers mentioned in the article.

Disclaimer: Investing involves risks of loss. You must decide for yourself whether you want to bear these risks or not.

Errors excepted: We have written this article to the best of our knowledge and belief. Our aim is to provide you as a private investor with the most objective and meaningful financial information possible. However, should we have made any errors, forgotten important aspects and/or no longer have up-to-date information, we would be grateful if you could let us know. test