It’s been a while since I’ve seen much in the news about Leveraged Exchange-Traded Funds (LETFs). Depending on what you read, these funds can seem like an exciting way to maximize returns, offering amplified exposure to stock performance. But beneath the surface, the math driving these financial products can produce unexpected and, sometimes, devastating outcomes for investors who don’t fully grasp the mechanics.
One striking example is the Europe-listed GraniteShares 3x Long MicroStrategy Daily ETP (LMI3). If you’re unfamiliar with MicroStrategy (MSTR), it is a software company now primarily known for investing in Bitcoin (read: volatility). The ETF promises three times the daily return of MicroStrategy Inc.’s stock. So, if MicroStrategy’s stock goes up 3% on a given day, LMI3 should rise by 9%. Conversely, if the stock drops by 5%, LMI3 falls by 15%. Sounds straightforward, right? Yet, despite MicroStrategy rising by more than 70% this year, LMI3 has dropped nearly 90% over the same period. This puzzling situation highlights the volatile and risky nature of leveraged ETFs.
The Mechanics of Leveraged ETFs
Leveraged ETFs like LMI3 are designed to multiply the daily return of an underlying stock (or index). To understand how this works, consider this simplified example. Imagine you purchase a share of a 3x leveraged ETF when the underlying stock is priced at $100. If the stock increases by 10% during the trading day, the ETF jumps by 30%, and its value rises from $100 to $130.
But here’s where things get tricky. Regardless of which way the stock moves — whether up or down — the ETF must adjust to maintain its leverage. This involves purchasing more stock when prices rise or selling stock when prices fall. For instance, if the stock increases 10%, the ETF must increase leverage to provide three times exposure to the new price, not just the original one. This daily rebalancing can lead to unexpected returns, especially in volatile markets.
If the stock decreases the next day, say by 9%, the ETF’s decline is threefold — meaning a 27% drop. In this scenario, the stock may end slightly higher than it began after two days, but the ETF could still lose value overall. This compounding effect can devastate long-term returns.
Leveraged ETFs and Volatility
Leveraged ETFs are designed to mirror daily returns, not long-term performance. This distinction is critical. The daily compounding of returns means that over extended periods, the ETF’s performance can diverge significantly from the underlying stock. Volatile stocks that experience large daily price swings further exacerbate this divergence.
Focusing on MicroStrategy, a stock known for its volatility, it has moved about 7% daily this year. In this case, when the stock price moves up or down dramatically day after day, the cumulative effect on the leveraged ETF can turn out much worse than simply multiplying the stock’s year-to-date return by three. In some cases, the leveraged fund can have a negative return, even if the stock performs well over the same period. Take a look at the 10-day example below for how quickly the performance can erode.
Not a Buy-and-Hold Product
One of the main takeaways from examining leveraged ETFs is that they are not suited for long-term holding. These products are rebalanced daily, and while they may offer amplified exposure to short-term price movements, holding them over weeks or months can lead to unexpected performance compared to the underlying stock.
In addition to the daily rebalance issues, the expenses are generally very high. The GraniteShares fund has an exceptionally high fee structure, at 0.09791% per day. That is over 30% in annual fees if you hold this product long-term, another excellent reason never to do so.
The Importance of Understanding Leveraged ETF Risks
While leveraged ETFs can be useful tools for specific professional traders looking to capitalize on short-term movements in volatile stocks, they come with considerable risks. The complex arithmetic behind these products means that even when the underlying stock performs well, the ETF can still underperform or, worse, lose value. As demonstrated by LMI3, a stock’s 70% gain doesn’t even guarantee a positive result, let alone a gain of 3x that.
For the vast majority of investors, these products should not be used, period. For the small minority that are well versed in how they work (risks, rewards, costs, etc.), these funds should still be cautiously approached and used only for short-term trades. While the idea of tripling your returns might sound tempting, in reality, the math can often work against you.
Economy
- It was a rough week for equities to start the month, with almost all of the economic news coming in weaker than expected. The S&P was down -4.2%, the Nasdaq was down -5.8%, and the small-cap Russell 2000 was down -5.6%.
- ISM Manufacturing PMI increased to 47.2 from the previous month, missing market expectations and reflecting the 21st monthly contraction in U.S. factory activity in the last 22 periods.
- The JOLTs report showed job openings down 237K to 7.673 million in July from a downwardly revised 7.910 million in June, reaching the lowest level since January 2021.
- The U.S. economy added 142K jobs in August 2024, more than a downwardly revised 89K in July but below forecasts of 160K.
- The unemployment rate in the U.S. eased to 4.2% in August from 4.3% in the prior month, aligning with market expectations.
Stocks
- U.S. equities were in negative territory. Technology and Energy led the decline, while Consumer Staples and Real Estate outperformed. Value stocks led growth stocks, and large caps beat small caps.
- International equities closed lower for the week. Emerging markets fared better than developed markets.
Bonds
- The 10-year Treasury bond yield decreased 20 basis points to 3.71% during the week.
- Global bond markets were in positive territory this week.
- Government bonds led for the week, followed by corporate bonds and high-yield bonds.
