Understanding The Riskiest, Most Complicated ETFs

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Key Takeaways:

• You can use leveraged ETFs to hedge or make big bullish or bearish bets against stocks. 
• Sounds amazing, however leveraged ETFs can be complicated, if not downright dangerous. 
• The Juice helps you navigate what you need to know about leveraged ETFs. 

What Is A Leveraged ETF? 

A leveraged ETF uses financial derivatives to (usually) double or triple the returns of an index, such as the Nasdaq-100. 

The key difference between a regular ETF and a leveraged ETF? A regular ETF aims to mimic the long-term performance of the underlying index it tracks. 

A leveraged ETF looks to reflect the daily returns of an index. Leveraged ETF managers rebalance their holdings every day to ensure the fund stays as close as possible to its stated goal. 

What Are The Goals Of Leveraged ETFs?

As noted, a leveraged ETF looks to double or triple the daily returns of the index it tracks. Some leveraged ETFs – inverse ETFs – want to see two or three times the inverse of an index’s daily performance. 

Let’s illustrate with an example, using the top two most searched for leveraged ETFs in our proprietary Trackstar database. 

The ProShares UltraPro Short QQQ (SQQQ) aims to produce daily returns that are three times (3x) the inverse (the opposite) of the Nasdaq 100 index (QQQ). 

The ProShares UltraPro QQQ (TQQQ) strives for daily returns that are three times the return of the Nasdaq 100 index. 

As short in SQQQ’s name gives away, it’s a bearish bet, whereas TQQQ reflects bullishness. 

Source: Google Finance 

This chart shows the performance of SQQQ, QQQ, and TQQQ on Friday, July 15, 2022. 

Both SQQQ and TQQQ did almost exactly what they advertise with TQQQ generating roughly 3x QQQ’s performance and SQQQ 3x the inverse of QQQ.  

As #4 and #5 on our Trackstar list indicate, you can make ultra bearish or bullish bets on very specific stock market indices, such as ones that track semiconductors or real estate. 

The possibilities are limitless. 

However, the utility of leveraged ETFs for everyday investors comes with serious considerations. 

Leveraged ETFs Are Not Long-Term Investments

First and foremost, intuitively you’d think you can extrapolate the one-day comparison between QQQ, SQQQ, and TQQQ out into the future. As in, SQQQ will be 3x lower than the long-term term performance of QQQ and TQQQ will generate returns 3x higher. 

Not the case. 

These ETFs have daily, not long-term goals. This is why they rebalance daily. To ensure they’re properly positioned to achieve this objective day in and day out. 

Second, they’re volatile. Clearly, if you’re holding TQQQ on a day the Nasdaq 100 declines, you’ll experience roughly 3x the decline. Same holds true in the inverse for SQQQ. 

Third, many experienced investors use leveraged ETFs as short-term hedges. They also trade them intraday attempting to profit from the market’s moves. 

Fourth, the high fees leveraged ETFs charge make them unsuitable for long-term investors. These ETFs charge high fees to compensate for the cost of buying the financial derivatives they use and the borrowing (margin) necessary to make these transactions. Plus, the managers make frequent trades to carry out the fund’s objective. 

The Bottom Line: While there might be a place for these instruments in your portfolio or as part of your trading activities, they require advanced knowledge of the overall mechanisms of the market as well as the specifics of leveraged ETFs themselves. 

The Juice scratched the surface here to, more than anything, warn you about common misconceptions and potential dangers associated with leveraged ETFs. Most investors probably have very little need to enter this relatively complicated territory. 

This said, if you decide to take the plunge, investigate further and make sure you know exactly what you’re doing before hitting the buy (or sell) button. 

On Friday, The Juice continues our series on ETFs by looking at some other types of ETFs you’re probably better off staying away from (as well as some worth your while).

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