Should Investors Use Leveraged ETFs or Avoid Them Altogether?

In markets where the S&P 500 is seemingly returning double digits every year, a lot of investors feel emboldened to try to amplify those returns even further.

Funds such as the ProShares UltraPro QQQ ETF (NASDAQ: TQQQ), which targets 3x the Nasdaq-100's daily performance, have been around for a long time. But the ETF industry has taken it to another level over the past couple of years. According to the ETF Action database, there are more than 430 leveraged funds available to investors. Over 270 of them are based on a single stock, and roughly two-thirds opened in the past year.

Leverage may be all the rage on Wall Street, but that doesn't necessarily make it a good idea. Use these funds in ways they're not intended, and the results could be disastrous.

Image source: Getty Images.

How leveraged ETFs actually work

Leveraged ETFs tied to stocks or equity indexes don't actually invest in stocks at all. They invest in derivative contracts that deliver a multiple of the underlying security's daily return. The "daily" part is important to highlight.

The ProShares UltraPro QQQ ETF, for example, is built to deliver triple the daily return of the Nasdaq-100. After the trading day ends, leverage is reset, and the cycle repeats the next day. If you hold a leveraged ETF beyond a single day, your returns could vary relative to the underlying index.

Unfortunately, the daily reset creates a mathematical drag called volatility decay. When an index fluctuates significantly without a clear trend, the compounding effect can work against the owner. If a leveraged fund falls by 10% and then rises by 10% on back-to-back days, it doesn't break even. If choppy trading persists for a long enough period, it can cause a leveraged product to lose money even as the underlying asset rises in value.

The numbers that investors should worry about

Data source: ProShares, Invesco, YCharts.

It's easy to look at the total return of the leveraged Nasdaq-100 ETF compared to that of the Invesco QQQ ETF (NASDAQ: QQQ) and conclude that the risk is worth it. But there are a few things to keep in mind.

• The 665% total return of TQQQ is less than three times the return of the Invesco QQQ ETF for the reasons mentioned earlier. Risk-adjusted returns for leveraged products are usually poorer than those of non-leveraged funds.
• Earnings that return would have required staying invested for drawdowns of 70% and 81%. Most investors would have bailed before that point and missed the rebound.
• Leverage can be costly. The expense ratio on the leveraged fund is more than quadruple that of the unleveraged ETF.

For most buy-and-hold investors, leverage isn't a good idea. Many investors struggle to avoid the temptation of emotional trading with unleveraged products. The anxiety that comes with 3x-leveraged funds can be considerably worse.

It's probably best to just stay away.

David Dierking has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.