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Leveraged ETFs—A Primer Thumbnail

Leveraged ETFs—A Primer

Michael Humphreys CFA® CAIA®

Introduction

Leveraged exchange traded products (ETPs)* are publicly traded funds that use derivatives** to multiply the performance of an underlying asset. Leveraged ETPs may provide leveraged exposure to a variety of financial products, including market indexes, specific stocks, commodities, fixed income, and cryptocurrency. The underlying exposures may be essentially long or short. Short positions are known as inverse ETPs and are products that profit from a decline in the value of the underlying (Chen, Scott, and Velasquez, n.d.). 

As of January 31, 2025, the net asset value (NAV) of leveraged exchange traded funds (ETFs), a subset of ETPs, was USD 134B, up 51% year-on-year (YoY) (Ptak 2025). Much of the recent growth in leveraged ETPs may be attributable to the recent marked attention on alternative investments (i.e., cryptocurrency) and the strong performance of equity markets. In the one-year period preceding Feb 7, 2025, a non-leveraged position in SPY would have returned a respectable 18%. However, a holder of a 2x Levered ETF on the S&P 500 would have gained 23%, outperforming SPY by 500 basis points (bps). The 500 bps of excess return carried far higher risk in the form of greater volatility and drawdown. However, for select investors, it appears the increased risk was warranted by the potential return.

Considerations

“Extra touchy funds” is the appellative professional investors and traders ascribe to leveraged ETPs (Zweig, n.d.) due to their inherently higher volatility. The greater the performance volatility of any financial product, leveraged or not, the more pronounced the difference between that instrument’s average arithmetic return and its geometric return, an effect known as volatility drag. 

Due to the multiplicative nature of leveraged ETPs, the differential between the arithmetic and geometric performance is amplified, creating higher levels of volatility drag than present in analogous non-leveraged ETPs. This increased volatility drag, when compounded over a period exceeding one day, exaggerates the performance gap between the leveraged and non-leveraged ETP. As more time passes, the gap grows, and eventually leveraged ETPs may find themselves significantly underperforming their non-leveraged peers. 

An example from Morningstar illustrates well the impact of volatility drag on leveraged ETFs. Mathematically, a loss requires an ever-greater gain so that an asset may recover its original value due to the compounding effect of returns. Imagine an investor who purchases a non-leveraged index ETF for USD 100. If that index falls 10% the following day, the investor must experience a gain of 11.1% to simply breakeven. Had the investor purchased a 2x leveraged ETF on that same index, and the index dropped the same 10%, that investor would now be down 20% on their initial investment. That 20% drop would require a commensurate 22.2% gain to recover. The point is large losses are exponentially more impactful than gains (Tran 2024). Thus, a leveraged fund will never have exactly the 2x or 3x performance of the underlying when held for a period exceeding 1 day. 

A second concern for leveraged ETFs is the management required to maintain the fund’s 2x exposure. As markets appreciate, portfolio managers must increase the fund’s derivative exposure, which requires buying in a rising market. Likewise, the same manager must sell in a falling market. The frequent buy high, sell low strategy augments the volatility drag innate in leveraged ETFs while also ballooning transaction costs (Tran 2024). 

Benefits

There is justification for the tactical inclusion of leveraged ETPs in an investment strategy. For example, leveraged ETPs are an effective means of increasing notional exposure to an asset or asset class when the investor has high conviction in the underlying’s direction and magnitude of return. However, market participants suggest an investor’s horizon should be predetermined and limited. In fact, financial regulators and leveraged ETP providers both advocate for the use of leveraged ETPs as a means of enhancing an expected return over a brief period, rarely exceeding a single day (Armour, Miller, and Hampton 2024). 

Nonetheless, the extraordinary bull market enjoyed by the S&P500 post-global financial crisis (GFC) has challenged the notion of levered ETPs as tools best reserved for tactical strategies. The Direxion Daily S&P500 Bull 3x ETF has returned 4,319.65% since 5 November 2008 versus the S&P500 TR benchmark’s 719.51%. The over 6x performance difference may help explain the 51% growth in NAV of leveraged funds. 


Based on a risk/reward analysis, the Direxion Daily experienced a staggering 46.54% annualized standard deviation of returns since inception versus the S&P 500 at 15.07%. Thus, on a risk per unit of return basis, the S&P easily outperformed the Direxion.


Focusing on drawdown, the Direxion Daily again significantly underperforms the S&P 500. Each downward move in the S&P translated to a far more adverse development in the Direxion, including multiple periods in which the drawdown exceeded 50%. A 50% or greater correction requires a 100% or greater gain to return the investor to their original position. 


Conclusion

Basing an investment decision on the absolute return performance of a fund like the Direxion Daily S&P500 Bull 3x ETF may present as highly rational. However, this single factor analysis would overly discount the effects of volatility, drawdown, and timing. Collectively, the impact of such factors can have a disquieting impact on an investor’s psyche, making it difficult to stay invested long enough to achieve the 6x outperformance. Moreover, Direxion may be more an exception than the rule when it comes to leveraged ETF performance. 

According to Bryan Armour of Morningstar Research, approximately 50% of US leveraged ETPs have been shuttered, evidencing the poor long-term performance of leveraged ETPs (Armour, Miller, and Hampton 2024). Before purchasing leveraged ETPs, an investor should have a clearly outlined rationale for the trade, complete with a defined holding period of no longer than a day. The volatile nature of leveraged ETPs can drive investors to make more emotionally founded asset allocation decisions. Such decisions will likely result in an increased probability of long-term sub-market performance. Beyond behavioral biases, the mathematical effect of volatility drag and higher costs also improves the odds of adverse performance. 

In conclusion, leveraged ETPs can be a valuable tool for investors to increase exposure to an investment opportunity without using margin. However, the products should be used parsimoniously and with clear intent. The long-term buy and hold of a leveraged ETP position increases investor risk and lowers their probability of significantly higher risk adjusted returns. When used as intended, leveraged ETPs can be simple and effective tools, but when approached less tactically, they can be devastating. 


*Exchange-traded products (ETPs) are instruments that track underlying securities, an index, or other financial products. ETPs trade on exchanges, meaning shares can be purchased, and prices can fluctuate throughout a trading day. ETP share prices are derived from the underlying investments that they track. Exchange-traded products can be benchmarked to myriad investments, including commodities, currencies, stocks, cryptocurrency, and bonds (Chen, Scott, and Velasquez, n.d.). ETPs include ETFs (exchange traded funds), ETNs (exchange trade notes), and ETCs (exchange traded commodities). 

**A derivative is a financial instrument whose value derives from an underlying asset such as a stock, a bond, interest rates, a commodity, an index, or even a basket of cryptocurrencies such as spot ether ETFs (Zucchi, Anderson, and Overcast, n.d.).


Sources

Armour, Bryan, Travis Miller, and Ivanna Hampton. 2024. “A Better Way to Use Leverage in Your ETF Portfolio.” Morningstar, Inc. November 1, 2024. https://www.morningstar.com/stocks/better-way-use-leverage-your-etf-portfolio-2.

Chen, James, Gordon Scott, and Vikki Velasquez. n.d. “Exchange-Traded Product (ETP): Definition, Types, and Example.” Investopedia. Accessed April 8, 2025. https://www.investopedia.com/terms/e/exchange-traded-products-etp.asp.

Chen, James, Gordon Scott, and Vikki Velasquez. n.d. “Inverse ETF: Definition, Comparison to Short Selling, and Example.” Investopedia. Accessed April 8, 2025. https://www.investopedia.com/terms/i/inverse-etf.asp.

Ptak, Jeffrey. 2025. “Why Leveraged ETFs Are for the Birds.” Morningstar, Inc. February 19, 2025. https://www.morningstar.com/funds/why-leveraged-etfs-are-birds.

Tran, Lan Anh. 2024. “Can Leveraged ETFs Benefit Your Portfolio?” Morningstar, Inc. November 20, 2024. https://www.morningstar.com/funds/can-leveraged-etfs-benefit-your-portfolio.

Zucchi, Kristina, Somer Anderson, and Kimberly Overcast. n.d. “Derivatives 101: A Beginner’as Guide.” Investopedia. Accessed April 8, 2025. https://www.investopedia.com/articles/optioninvestor/10/derivatives-101.asp.

Zweig, Jason. n.d. “How to Make 267%—or Lose 90%—on Treasury Bonds - WSJ.” Accessed April 2, 2025. https://www.wsj.com/finance/investing/levereged-inverse-etfs-treasurys-d4fa4e62.


This material is intended for educational and informational purposes only. It is not intended to provide specific advice or recommendations for any individual. Additionally, you should consult with your Financial Advisor, Tax Advisor, or Attorney on your specific situation. The views expressed in the material are that of the author and do not necessarily reflect those of any market, regulatory body, State or Federal Agency, or Association. All efforts have been made to report or share true and accurate information. However, the information may become materially outdated or otherwise rendered incorrect due to subsequent new research or other changes, without notice. The author nor the firm are able to always verify the content from third-party sources. For additional information about the firm, please visit the MAS Website at https://www.mas.gov.sg/  and the SEC Website at www.adviserinfo.sec.gov. For a copy of the firm's ADV Part 2 Brochure, please contact us at info@avriowealth.com.