Leveraged ETFs Promise Bigger Returns. Here Is Why Long-Term Investors Should Weigh the Risks First

Investors often use exchange-traded funds (ETFs) to achieve instant diversification across a single sector, region, or index. For example, Vanguard's S&P 500 ETF (NYSEMKT: VOO) passively tracks the entire S&P 500 for a low fee, making it an easy solution for people who want to stay invested but don't have time to track individual stocks.

However, investors seeking larger gains might start flirting with leveraged ETFs, which often aim to double or triple the return of an underlying stock or index. These ETFs might seem tempting, but long-term investors should carefully weigh their risks against the potential rewards.

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How do leveraged ETFs work?

To understand how leveraged ETFs work, let's take a look at Direxion's Daily S&P 500 Bull 3x Shares (NYSEMKT: SPXL), which aims to triple the daily performance of the S&P 500.

To accomplish that, Direxion does a "total return swap" with a bank. For example, if Direxion wants to invest $100 million in the S&P 500, the bank invests $300 million in the S&P 500 for the fund. Every day that "synthetic loan" is active, the bank pays Direxion triple the daily return of the S&P 500. In return, Direxion pays the bank interest on the contract until it expires.

To cover those interest payments, leveraged ETFs charge much higher fees than traditional ETFs. That's why SXPL's net expense ratio of 0.84% is much higher than VOO's ratio of 0.03%.

Leveraged ETFs also only work if you're confident in the underlying investment's movements, since they magnify your losses if they move in the opposite direction. For example, SPXL might triple the S&P 500's gain on a green day, but it will also triple the index's losses on a red day.

Another thing many investors miss is that most leveraged ETFs reset their returns every day. Therefore, holding a leveraged ETF for long periods through sideways markets generally erodes your returns because you're essentially starting a fresh position (minus fees) every day. However, some newer leveraged ETFs -- such as those from Tradr -- address that issue by only resetting their returns weekly, monthly, or quarterly. Nevertheless, leveraged ETFs are typically considered short-term tactical trading tools rather than long-term investments.

Lastly, all leveraged ETFs have a counterparty risk. If the bank handling the ETF's total return swap faces liquidity issues or goes bankrupt, the fund would likely collapse as well. During the COVID crash in 2020, around 30 leveraged ETFs and exchange-traded notes (ETNs) -- debt that tracks the returns of underlying indexes without actually owning any equity -- collapsed. Over the long term, more than half of all leveraged ETFs eventually failed, due to a combination of market volatility, compounded losses, and divergences from their underlying investments.

When does it make sense to buy leveraged ETFs?

Leveraged ETFs are risky, but the largest ones might still be good long-term investments. If you believe the S&P 500 -- which has generated an average annual return of 10% since its inception in 1957 -- will continue rising, then it might still be smarter to buy SPXL instead of VOO.

Over the past five years, SPXL rallied by more than 140%, while VOO rose by only 70%. It didn't triple the S&P 500's return, since the fund reset its gains every day, but it still doubled it.

It makes less sense to invest in leveraged ETFs that short the market as long-term investments. For example, Direxion Daily S&P 500 Bear 3X ETF (NYSEMKT: SPXS) aims to deliver -300% of the S&P 500's daily performance. Yet over the past five years, its shares have plummeted nearly 90% as the S&P 500 set new record highs. It's also risky to invest in leveraged ETFs pinned to a single stock, like Direxion's Daily NVDA Bull 2X ETF (NASDAQ: NVDU).

Leveraged ETFs might make sense in certain situations, but long-term investors need to understand how they work and why they're less reliable than traditional ETFs. They should also recall that John Bogle, the founder of Vanguard and creator of the first index fund, once called leveraged ETFs "gambling" tools that were "beyond" his comprehension.

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