Are Leveraged ETFs Smart Tools or Speculative Bets?

Leveraged exchange-traded funds (ETFs) initially sound like cheat codes to double your exposure to a publicly traded company without taking out margin. However, these same funds can decimate your portfolio, and it gets worse the longer you hold on to them. The mechanics of these funds do not warrant long-term positions in your portfolio since they are different from actual margin trading.

It's much better to buy and hold individual stocks for the long run instead of trying to make flashy plays with margin and leveraged ETFs. These are some of the reasons leveraged ETFs are nothing more than speculative bets, even though they may look like smart tools to investors who don't know the intricacies of these types of funds.

Leveraged ETFs have the same risk as margin

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Many investors who like the idea of leveraged ETFs view them as a way to multiply exposure to assets without going into debt. You don't need margin to buy these funds, but they have the same risk as going into debt.

For instance, the ProShares Ultra NVDA ETF (NYSEMKT: NVDB) gives investors double the exposure to Nvidia. If the company's stock rises by 1%, the ETF will rise by 2%. A 20% rally for Nvidia translates into a 40% gain for the ETF. It sounds like a winning formula.

However, Nvidia can also fall by 20% without any shake-up in its fundamentals. Macroeconomic conditions can be enough to rattle highly volatile stocks, and if that 20% drop happens, the ProShares fund would be down by 40%.

This is how margin works, and you will expose yourself to the same risks with a leveraged ETF. Your money can grow or shrink much faster, and that type of speculation does not belong in most people's portfolios.

Decay risk and high expense ratios add up quickly

When you take out margin, you only have to worry about interest rates and avoiding a margin call. These are stresses most investors shouldn't be dealing with, and you don't have to put that extra burden on yourself to reach your retirement goals. There are other ways to build your portfolio, such as investing in high-quality stocks, starting a side hustle, or seeking a higher-paying job.

And the problems are compounded with leveraged ETFs. The first fact is that they have high expense ratios. The ProShares Nvidia ETF has a 0.95% net expense ratio. That's extremely high. You're giving up almost $1 per year for every $100 you keep in the fund.

Index funds like the Vanguard S&P 500 ETF have only a 0.03% expense ratio, compared to the expense ratio for ProShare's Nvidia ETF.

That's not even the worst part. Leveraged ETFs go through a unique problem called decay risk due to their daily rebalancing. These funds reset daily to preserve their exposure ratios. If an underlying asset drops by 10%, then a 2x leveraged ETF drops by 20%. However, the fund manager will have to sell stocks to maintain a 2x leverage due to how margin works.

For instance, if a 2x leveraged ETF has $100 in assets, it has $200 in exposure. A 10% drop in the stock would leave a regular stock investor with $90. However, the same drop for a 2x leverage ETF is a $40 loss, taking it down to $60 in assets and $160 in exposure.

The fund must then sell $40 at a loss to maintain 2x exposure. In this case, it's $60 in assets and $120 in exposure. This happens every day and limits the gains you will get from recovery rallies.

You just needed an 11.1% gain from the underlying stock to get back to breakeven, but the fund needs a 66.6% gain to reclaim its original price. That's the hidden risk of leveraged ETFs.

This decay gets worse the longer you hold a fund, so you can end up outperforming while saving a lot of stress if you invest in stocks for the long term instead.

Marc Guberti has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Nvidia and Vanguard S&P 500 ETF. The Motley Fool has a disclosure policy.