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Are Leveraged Funds Worth It?

Increasing risk/ return using leveraged funds

Some of my younger friends are big fans of leveraged ETFs. This got me wondering if they were worth it or not. 

First, what are they?

A leveraged ETF is an exchange-traded fund designed to track an index or asset and amplify its daily returns, often by two or three times. 

One of the more popular leveraged funds is SSO - ProShares Ultra S&P 500. This is a 2x leverage fund that aims to deliver twice the daily return of the S&P 500. So if the S&P 500 went up 1% that day the fund’s goal is to return 2%.

These funds work the opposite way too, if the S&P 500 goes down 1%, you expect SSO to go down 2%.

The concept of them isn’t terribly complex, and most investors understand the mechanics and risks.

One additional thing to mention. Leveraged funds amplify decay risk. What is decay risk? Decay risk is a decline in value when investments are flat over a period. It’s much easier to explain if I show you an example: 

Day 1:

  • Underlying Index: +1%

  • Expected ETF Return: 2% (2x daily return)

  • ETF Value: 100 * (1 + 2%) = 102

Day 2:

  • Underlying Index: -1%

  • Expected ETF Return: -2% (2x daily return)

  • ETF Value: 102 * (1 - 2%) = 99.96

Day 3:

  • Underlying Index: +1%

  • Expected ETF Return: 2% (2x daily return)

  • ETF Value: 99.96 * (1 + 2%) = 101.95

In this 3 day example you had a simple return of 2%, but a compounded return of 1.95%. This is decay risk.

Note: all investments have decay risk, but leveraged funds experience greater decay risk because of the additional costs they have using derivatives or paying interest on the debt they use for the leverage.

Ok now to finally answer the question, are leveraged ETFs worth it?

For 99%+ of investors I don’t think so. For the very aggressive and very disciplined investors I can understand the argument.

Discipline is paramount for a leveraged fund investor. If we have a market dip or a flat period they need to be willing to hold on long enough for the market to come back.

This is easy to say, very hard to do. 

Why would I steer 99% of investors away from them?

Let’s look at 2022. 

In 2022 the return of SSO was -38%!! This is expected, the market had a tough year and if you’re using leverage you’re amplifying that return. (For those asking: 2008 return was -67%.)

Return of SSO during 2022

SSO performance summary for 2022

If I asked twenty investors if they could hold on during a 38% drop all twenty would tell me they could, but I know better to believe them. 

One, maybe two could actually stomach that drop.

It’s human nature to react greater to losses than gains (called loss aversion) and I know most investors would abandon this strategy during a drop of this much. This is locking in losses--the cardinal sin of investors.

I know I am in this category. I wouldn’t be able to hold on during this drop. That’s why I don’t use leveraged funds.

Final answer: I don’t think they’re worth it. I think 99.9% of us should stop trying to beat the market, take the 8-10% long term average and focus on something else.

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