Why 3x ETFs Are Riskier Than You Might Think (2024)

Leverage involves borrowing in order to amplify the returns of an investment. This means that potential gains, but also losses, can be increased. A common form of leveraged stock investing involves buying on margin. However, there are also ETF products that already come with leverage built-in, seeking 2x or 3x the returns of the index or sector that they track.

Investors face substantial risks with all leveraged investment vehicles. However, 3x exchange-traded funds (ETFs) are especially risky because they utilize more leverage in an attempt to achieve higher returns. Leveraged ETFs may be useful for short-term trading purposes, but they have significant risks in the long run.

Key Takeaways

  • Triple-leveraged (3x) exchange-traded funds (ETFs) come with considerable risk and are not appropriate for long-term investing.
  • Compounding can cause large losses for 3x ETFs during volatile markets, such as U.S. stocks in the first half of 2020.
  • 3x ETFs get their leverage by using derivatives, which introduce another set of risks.
  • Since they maintain a fixed level of leverage, 3x ETFs eventually face complete collapse if the underlying index declines more than 33% on a single day.
  • Even if none of these potential disasters occur, 3x ETFs have high fees that add up to significant losses in the long run.

Understanding 3x ETFs

As with other leveraged ETFs, 3x ETFs track a wide variety of asset classes, such as stocks, bonds, and commodity futures. The difference is that 3x ETFs apply even greater leverage to try to gain three times the daily or monthly return of their respective underlying indexes. The idea behind 3x ETFs is to take advantage of quick day-to-day movements in financial markets. In the long term, new risks arise.

Because of how leveraged ETFs are constructed, they are only intended for very short holding periods, such as intraday. Over time, their value will tend to decay even if the underlying price movements are favorable.

Compounding and Volatility

Compounding—the cumulative effect of applying gains and losses to a principal amount of capital over time—is a clear risk for 3x ETFs. The process of compounding reinvests an asset's earnings, from either capital gains or interest, to generate additional returns over time. Traders calculate compounding with mathematical formulas, and this process can cause significant gains or losses in leveraged ETFs.

Assume an investor has placed $100 in a triple-leveraged fund. Consider what happens when the price of the benchmark index goes up 5% one day and down 5% on the next trading day. The 3x leveraged fund goes up 15% and down 15% on consecutive days. After the first day of trading, the initial $100 investment is worth $115. The next day after trading closes, the initial investment is now worth $97.75. That represents a loss of 2.25% on an investment that would normally track the benchmark without the use of leverage.

Volatility in a leveraged fund can quickly lead to losses for an investor. Those looking for real-world examples of this phenomenon need look no further than the performance of the S&P 500 and associated 3x ETFs during the first half of 2020. Funds like the ProShares Ultra S&P500 (SSO), which follows the S&P500 with 3x leverage, lost 40% of their value between January and March of that year.

The effect of compounding can often lead to quick temporary gains. However, compounding can also cause permanent losses in volatile markets.

Derivatives

Many 3x ETFs use derivatives—such as futures contracts, swaps, or options—to track the underlying benchmark. Derivatives are investment instruments that consist of agreements between parties. Their value depends on the price of an underlying financial asset. The primary risks associated with trading derivatives are "market," "counterparty," "liquidity," and "interconnection" risks. Investing in 3x ETFs indirectly exposes investors to all of these risks.

Daily Resets and the Constant Leverage Trap

Most leveraged ETFs reset to their underlying benchmark index on a daily basis to maintain a fixed leverage ratio. That is not at all how traditional margin accounts work, and this resetting process results in a situation known as the constant leverage trap.

Given enough time, a security price will eventually decline enough to cause terrible damage or even wipe out highly leveraged investors. The Dow Jones, one of the most stable stock indexes in the world, dropped about 22% on one day in October of 1987. If a 3x Dow ETF had existed then, it would have lost about two-thirds of its value on Black Monday. If the underlying index ever declines by more than 33% on a single day, a 3x ETF would lose everything. The short and fierce bear market in early 2020 should serve as a warning.

High Expense Ratios

Triple-leveraged ETFs also have very high expense ratios, which make them unattractive for long-term investors. All mutual funds and exchange-traded funds charge their shareholders an expense ratio to cover the fund’s total annual operating expenses. The expense ratio is expressed as a percentage of a fund's average net assets, and it can include various operational costs. The expense ratio, which is calculated annually and disclosed in the fund's prospectus and shareholder reports, directly reduces the fund's returns to its shareholders.

Even a small difference in expense ratios can cost investors a substantial amount of money in the long run. 3x ETFs often charge around 1% per year. For example, the ProShares Ultra Pro QQQ, which seeks to triple the daily returns of the NASDAQ 100, has a gross expense ratio of 0.98%.

Compare that with typical stock market index ETFs, which usually have minuscule expense ratios under 0.05%. A yearly loss of 1% amounts to a total loss of more than 26% over 30 years. Even if the leveraged ETF pulled even with the index, it would still lose by a wide margin in the long run because of fees.

What Does It Mean When an ETF Is Leveraged 3x?

An ETF that is leveraged 3x seeks to return three times the return of the index or other benchmark that it tracks. A 3x S&P 500 index ETF, for instance, would return +3% if the S&P rose by 1%. It would also lose 3% if the S&P dropped by 1%.

What Research Is Needed to Trade in Triple Leveraged ETF?

Leveraged ETFs require considerations such as how they are constructed and how often their portfolio is rolled over and rebalanced. For instance, some may use options contracts while others used structured notes. Leveraged ETFs also tend to have relatively high expense ratios, which should be considered.

What Happens If Triple Leveraged ETFs Go to Zero?

Leveraged ETF prices tend to decay over time, and triple leverage will tend to decay at a faster rate than 2x leverage. As a result, they can tend toward zero. Before this happens, leveraged ETFs can undertake a reverse stock split, creating higher-priced shares but reducing the number of ETF units outstanding. Ultimately, if the share prices drop low enough and there is no demand for a reverse split, the ETF may be delisted.

The Bottom Line

A leveraged ETF uses derivative contracts to magnify the daily gains of an index or benchmark. These funds can offer high returns, but they also come with high risk and expenses. Funds that offer 3x leverage are particularly risky because they require higher leverage to achieve their returns.

Why 3x ETFs Are Riskier Than You Might Think (2024)

FAQs

Why 3x ETFs Are Riskier Than You Might Think? ›

A leveraged ETF uses derivative contracts to magnify the daily gains of an index or benchmark. These funds can offer high returns, but they also come with high risk and expenses. Funds that offer 3x leverage are particularly risky because they require higher leverage to achieve their returns.

Why are ETFs riskier? ›

ETFs are subject to market fluctuation and the risks of their underlying investments. ETFs are subject to management fees and other expenses. Unlike mutual funds, ETF shares are bought and sold at market price, which may be higher or lower than their NAV, and are not individually redeemed from the fund.

Why are leveraged ETFs bad? ›

Leveraged ETFs decay due to the compounding effect of daily returns, volatility of the market and the cost of leverage. The volatility drag of leveraged ETFs means that losses in the ETF can be magnified over time and they are not suitable for long-term investments.

What are the 3 advantages of leveraged ETFs? ›

The various advantages of leveraged ETFs are:
  • Leveraged ETFs trade their shares in the open market like stocks.
  • Leveraged ETFs amplify daily investor earnings and enable traders to generate returns and hedge them from potential losses.
  • Leveraged ETFs mirror the returns of investors of an index with few tracking errors.

What are 3 disadvantages to owning an ETF over a mutual fund? ›

Disadvantages of ETFs
  • Trading fees. Although ETFs are generally cheaper than other lower-risk investment options (such as mutual funds) they are not free. ...
  • Operating expenses. ...
  • Low trading volume. ...
  • Tracking errors. ...
  • The possibility of less diversification. ...
  • Hidden risks. ...
  • Lack of liquidity. ...
  • Capital gains distributions.

Why 3x ETFs are riskier than you might think? ›

A leveraged ETF uses derivative contracts to magnify the daily gains of an index or benchmark. These funds can offer high returns, but they also come with high risk and expenses. Funds that offer 3x leverage are particularly risky because they require higher leverage to achieve their returns.

Is it bad to invest in too many ETFs? ›

The disadvantages are complexity and trading costs. With so many ETFs in the portfolio, it's important to be able to keep track of what you own at all times. You could easily lose sight of your total allocation to stocks if you hold 13 different stock ETFs instead of one or even five.

What is the most volatile 3x ETF? ›

The Direxion Daily Junior Gold Miners Index Bull 3x Shares (JNUG) and the Direxion Daily Junior Gold Miners Index Bear 3x Shares (JDST) are the two most volatile exchange-traded funds of all. Each has a one-year volatility reading of about 170.

Why is leverage so risky? ›

Leverage can multiply your losses every bit as much as it can multiply your profits – which makes it a risky tool. But that doesn't necessarily mean you should avoid it altogether. Next, we'll look at how you can handle leverage sensibly.

Why are leveraged deals risky? ›

That opportunity comes with high risk for investors because leverage amplifies losses in downturns. For businesses, leverage creates more debt that can be hard to pay if the following years present slowdowns.

What is a leveraged ETF for dummies? ›

Leveraged ETFs use derivatives to multiply returns on an index by ratios like 2:1 or 3:1. Inverse-leveraged ETFs track an index in reverse. Single-stock leveraged ETFs use derivatives to track a single stock instead of an index or asset class.

What is the 3 ETF strategy? ›

A three-fund portfolio is a portfolio which uses only basic asset classes — usually a domestic stock "total market" index fund, an international stock "total market" index fund and a bond "total market" index fund.

What is leverage in simple words? ›

to use something that you already have in order to achieve something new or better: We can gain a market advantage by leveraging our network of partners. SMART Vocabulary: related words and phrases.

Has an ETF ever gone to zero? ›

Further, after about three years, the 80th percentile line also begins its decent toward zero. Over even longer time horizons, every percentile (except the 100th) of the ETF's value will eventually converge to zero.

Why are ETFs riskier than mutual funds? ›

While these securities track a given index, using debt without shareholder equity makes leveraged and inverse ETFs risky investments over the long term due to leveraged returns and day-to-day market volatility. Mutual funds are strictly limited regarding the amount of leverage they can use.

What is the primary disadvantage of an ETF? ›

Buying high and selling low

At any given time, the spread on an ETF may be high, and the market price of shares may not correspond to the intraday value of the underlying securities. Those are not good times to transact business.

Are ETFs riskier than mutual funds? ›

The short answer is that it depends on the specific ETF or mutual fund in question. In general, ETFs can be more risky than mutual funds because they are traded on stock exchanges.

Is it possible to lose money on ETF? ›

An ETF with a low risk rating can still lose money. ETFs do not provide any guarantees of future performance. As with any investment, you might not get back the money you invested.

Has an ETF ever failed? ›

ETF closures are rare, but they do happen.

Is trading ETFs risky? ›

Key Takeaways. ETFs can be safe investments if used correctly, offering diversification and flexibility. Indexed ETFs, tracking specific indexes like the S&P 500, are generally safe and tend to gain value over time. Leveraged ETFs can be used to amplify returns, but they can be riskier due to increased volatility.

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