The Truth About Leveraged ETFs

Ben Felix

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Video Summary

Leverage, the use of financing to amplify asset exposure, presents a double-edged sword, capable of boosting returns or leading to catastrophic losses. While theoretically beneficial for young investors with substantial human capital, the assumption of 'safe' human capital is often flawed, as real-world incomes can be volatile and correlated with market downturns. Research suggests that for well-diversified long-term investors, daily reset leveraged index ETFs, contrary to popular belief, do not inherently cause value destruction through volatility drag.

However, the practical application of leverage is fraught with challenges. High financing costs and fees can significantly erode returns, particularly for single-stock leveraged ETFs, where investors have a high probability of substantial losses. While leveraged ETFs offer convenience and simplicity, their extreme volatility, exemplified by significant drops during market crises, poses a considerable psychological hurdle for most investors. The decision to employ leverage requires a deep understanding of its risks, a tolerance for extreme fluctuations, and careful consideration of individual circumstances, with single-stock leveraged ETFs appearing particularly ill-advised.

Short Highlights

Leverage amplifies both gains and losses, making it a risky investment tool.
Young investors with high human capital could theoretically benefit from leverage, but this assumption is often unrealistic.
Daily reset leveraged ETFs, contrary to common belief, do not inherently cause value destruction.
High costs, including financing and fees, can significantly reduce the effectiveness of leveraged ETFs.
Single-stock leveraged ETFs present a particularly high risk of substantial investor losses.
Extreme volatility in leveraged ETFs can lead to significant psychological distress for investors.
The decision to use leverage requires careful consideration of personal risk tolerance and financial goals.

Key Details

The Power and Peril of Leverage [0:00]

Investing $10,000 in a ProShares UltraPro S&P 500 3X leveraged ETF at its 2009 launch could yield $1.3 million today, significantly outperforming a regular S&P 500 ETF.
Leverage, defined as using financing for asset exposure exceeding one's equity, can be a sensible allocation tool but also a potential disaster.

"Leverage amplifies the amount of exposure that you get to an asset for each dollar that you invest in it."

Theoretical Case for Leverage in Early Life [1:21]

Young individuals with high human capital (future earning potential) and low financial wealth are theoretically advised to borrow and invest.
This strategy assumes human capital acts as a safe, bond-like asset, balancing out the risk of stock investments.
Formalized by researchers like Paul Samuelson and Robert Merton, this concept suggests young workers with safe future earnings should optimally use leverage.

"The idea is that if, and that's a big if that I'm going to come back to later, if your human capital is a safe bond-like asset, and you have low financial assets, meaning investments in things like stocks and bonds, your overall asset allocation early in life is concentrated in safe assets in your human capital, while lacking exposure to risky assets like stocks."

Interrogating the 'Safe Human Capital' Assumption [3:10]

The assumption of safe human capital is critical and potentially flawed, as young people may have riskier career paths.
High-income households often experience income declines correlated with stock market downturns, forcing them to sell assets at a loss.
Fixed expenses like mortgages and daycare make it difficult for households to adjust spending when income falls, leading to asset liquidation.

"There's also evidence that many high-income households' wage and business incomes do decline at the same time as the stock market, and that they sell some of their liquid assets, including their stock holdings, to make up the income shortfall during these bad times."

Leveraging Human Capital: A Diversification Approach [5:29]

A 2013 paper suggests 2x leverage for young investors, declining over time, as a practical approach.
This strategy is compared to a non-leveraged portfolio, showing similar accumulation outcomes but with higher wealth volatility in the leveraged scenario.
The model's target allocation is based on the Merton-Samuelson share, calculated using expected equity risk premium, variance, and risk aversion.

"The authors of that paper treat human capital as an asset in the portfolio and showed that a young worker with little financial wealth whose future earnings are relatively safe, optimally uses leverage to reach their target equity exposure."

The Reality of Volatility and Wipeouts [8:40]

Leverage significantly increases volatility and can lead to total wipeouts of financial assets, which is psychologically devastating.
A 2x leveraged S&P 500 ETF dropped nearly 80% during the 2008 financial crisis, and a 3x ETF saw similar losses at the start of the COVID-19 pandemic.
Long-term holding of leveraged funds is compared to living in a sensory deprivation tank due to the extreme short-term downside events.

"Buying a leveraged fund and holding it for the long run is appropriate only for people who can spend the rest of their lives in a sensory deprivation tank."

Debunking Volatility Decay in Leveraged ETFs [13:01]

The long-term effect of daily leverage maintenance, known as volatility decay, has been a concern, but recent research challenges this.
Mathematical approximations show that the cost of volatility is insensitive to rebalancing frequency, provided returns are not serially correlated.
Empirical studies on index-based leveraged ETFs suggest that daily resets do not inherently lead to underperformance compared to static leveraged portfolios.

"The authors conclude that daily leverage resets in leveraged ETFs are not the problem they have historically been made out to be."

The High Costs and Risks of Leveraged ETFs [18:30]

Expense ratios for leveraged ETFs are around 1%, but total costs, including financing spreads, can exceed 5% annually for 2x leveraged index ETFs.
Single-stock leveraged ETFs face significantly higher financing costs, pushing total costs towards 12% and increasing the likelihood of substantial investor losses.
Research indicates that investors in single-stock leveraged ETFs are more likely to lose over 75% of their investment than to outperform the underlying stock.

"Single-stock leveraged ETFs have market cap-weighted financing spreads nearly 10 percentage points above the risk-free rate, which is crazy, putting the total cost of a 2x leveraged single-stock ETF close to 12%."