We used the 3x S&P 500 index as an example to show that leveraged ETFs will underperform in the long term. Now we will discuss the first reason for such under-performance.
The Daily Compounding Trap
The 3x S&P 500 index ETF is designed to return three times of the S&P 500 return, on a daily basis, by using the derivatives. Consequently, if the S&P 500 returns 1%, the SPXL should return about 3%.
However, such daily compounding won't necessarily lead to the same effect long term.
For example, if the S&P 500 moves down 10% a day, the SPXL should move down 30% at the same day. On the second day, if S&P 500 goes up 10%, over these two days, the S&P 500 return will be down 1%. You would expect SPXL to be down 3%, right?
Wrong.
SPXL will be actually down 9%, making it effectively a 9X leveraged ETF for this period!
Generally, the more volatile a benchmark index is, the more value the levered ETF will lose over time. If the benchmark index moved flat at the end of the investment period but had drastic up or downs along the way, a long term buy and hold investor of the leveraged ETF will lose big!
There is one more reason why levered ETF is not for long term investors.
The Daily Compounding Trap
The 3x S&P 500 index ETF is designed to return three times of the S&P 500 return, on a daily basis, by using the derivatives. Consequently, if the S&P 500 returns 1%, the SPXL should return about 3%.
However, such daily compounding won't necessarily lead to the same effect long term.
For example, if the S&P 500 moves down 10% a day, the SPXL should move down 30% at the same day. On the second day, if S&P 500 goes up 10%, over these two days, the S&P 500 return will be down 1%. You would expect SPXL to be down 3%, right?
Wrong.
SPXL will be actually down 9%, making it effectively a 9X leveraged ETF for this period!
Generally, the more volatile a benchmark index is, the more value the levered ETF will lose over time. If the benchmark index moved flat at the end of the investment period but had drastic up or downs along the way, a long term buy and hold investor of the leveraged ETF will lose big!
There is one more reason why levered ETF is not for long term investors.
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