If you make the right call, you could make a bonanza with leveraged funds. For example, the Direxion Daily Natural Gas Related Bear 3X Shares fund (GASX) was the top-performing ETF in 2018 with a 128% return. Note the “Bear” in the fund’s name, signaling that it’s an inverse leveraged ETF designed to move in the opposite direction of a benchmark or index by an inverse of one or by multiples of the inverse—in the case of the GASX fund, by a multiple of three.
But the highly levered directional bet represented by these funds can drastically compound a misplaced bet, as demonstrated by the 89% plunge in GASX in 2016.
That’s why Mallen believes leveraged ETFs are best suited for investors anticipating a rapid short-term move. “For longer-term time horizons, options are the way to go,” he says.
Indeed, leveraged ETFs tend to deviate from their expected return over longer time frames, what many investors assume to be tracking error in relation to the underlying index. For example, the S&P 500 fell 6.2% in 2018, while the UltraPro S&P500 fund (which, as noted before, uses three times leverage), fell 25.5% last year, rather than by 18.6%, as some investors might have anticipated.
That’s the result of very choppy trading conditions in 2018, which makes it harder for these ETFs to maintain a constant and fairly fixed exposure to their underlying index.
“Leveraged ETFs are not meant to track the underlying market’s week-to-week, month-to-month or year-to-year performance,” says Bombardia. “They are meant to track the underlying market’s day-to-day performance.”
A fund’s inability to accurately track an especially volatile underlying index over time is known as “decay,” and it results from the multiplying effect on returns from constant daily leverage. And that spells opportunities for investors who aim to profit from inverse leveraged ETFs that move in the opposite direction of an underlying index. When a leveraged ETF tracks a particularly volatile underlying index (such as natural gas or Indian stocks), it can fall out of sync as such assets rise and fall sharply. The longer you own them, the less likely they are to deliver the two times or three times they aim to accomplish. As a result, shorting leveraged ETFs that target such highly volatile assets can pay off simply because of the decay factor. “The underlying market doesn’t even need to fall in order for you to make money,” Bombardia said.
Undoubtedly, options traders are unlikely to abandon their favorite asset class. It’s what they know best. Yet for investors in ETFs who aim to also profit from short-term directional shifts, leveraged ETFs may be a better vehicle than many realize. On the long side, they can deliver gains in excess of what that “X” factor might suggest. And on the short side, they can bring the benefits of leverage and also the added element of decay.
Even so, you have to keep these funds on a short leash to avoid getting burned by sudden moves in the opposite direction from what you intended.