In the stock market, the pos-Covid 19 Era has seen an extraordinary rally since the US Federal Reserve (Fed) decided to step in to stabilize the financial markets back in March 2020. This “non-stoppable” recovery did not look behind as the vaccines started to emerge, and the real economy (manufacturing and services activities) showed signs of improvement at a faster pace than previously expected.
However, the fundamental gap between the US and European Stocks did not converge from the past years. The dispersion even became wider. Using the S&P 500 and the STOXX Europe 600 as the indices references for the US and Europe, respectively, you can clearly notice this behaviour:
As of April 2021, STOXX Europe 600 traded at 15 times the expected 12-month earnings (forward P/E) of its members. In contrast, America’s S&P 500 traded at a punchier 21 times.
So, the opportunity to invest in an ETF tracking a European Index might be a good relative trade for the long run. The million-dollar question: How to do it most effectively?
Is a Leveraged Europe ETF a good choice?
Whether you believe in the gap convergence between the US and European stocks market, it may be tempting to invest in a leveraged ETF since the expected return is much higher than just using a 1x ETF that mimics the performance of the underlying index. However, it would help if you were prudent when considering investing through a leveraged Europe ETF rather than a non-leveraged ETF rather. Let us explain to you why!
Firstly, you should understand the very nature behind a leveraged ETF. The objective is to seek a return of X times (2x, 3x,…) the return of its underlying benchmark for a single day before fees and expenses. There is a reason why “single day” is in bold. It is the most critical part of this story due to the daily resets.
Imagine the following situation: You have an ETF replicating a stock index that promises you to pay 2x the return of that index. In your mind, you may be thinking: “So, if the index rises 20% in 5 days, I would have a gross return of 40%, am I right?” Unfortunately, that may not be the case.
Take a closer look at the following table:
|
|
Non-Leveraged ETF |
2x Leveraged ETF |
|||
|
Days |
Index price movement | Return | Portfolio value | Return | Portfolio Value |
|
0 |
– | – | $100 | – |
$100 |
|
1 |
-10% | -10% | 100-(0.10*100)=90 | -20% |
100-(0.20*100)=80 |
|
2 |
-15% | -15% | 90-(0.15*90)=76.5 | -30% |
80-(0.30*80)=56 |
| 3 | +10% | +10% | 76.5*1.10=84.15 | +20% |
56*1.20=67.20 |
| Final Result | $84.15 (-15.85%) |
$67.20 |
|||
On day 1, the index falls by 10% and the non-leveraged ETF and the 2x leveraged ETF perform their jobs: -10% and -20%, respectively. On day 2, the same process applies. On day 3, the final result is $84.15 and $67.29 for the non-leveraged ETF and the 2x leveraged ETF, respectively. In other words: a -15.85% return for the former and -32.80% return for the latter.
Weren’t you expecting the double of the loss for the 2x Leveraged ETF, were you? Meaning a negative 31.70% return? The difference of -1.1% (-32.80%-(-31.70%)) is not a rounding error. In this example, it is small, but it will extend over several periods. Besides, after considering the interest, transactions and management expenses, your overall performance may severely suffer.
Another example: Let’s analyze the ProShares Short S&P500, an ETF that seeks to give you the inverse (-1x) of the daily performance of the S&P 500. In the image below, you will notice a +46.5% return on the S&P 500. An intuitive thought would be to get a -46.5% return on the inverse ETF, but the final result is very different from expected (-66.1%).
The negative impact of high leverage in downturns can be summarized in the following table:
Source: fusioninvesting.com
Usually, the magnitude of the rise is not enough to compensate for the previous loss. That’s why you observe returns that are lower than the ones intuitively imagined.
Bottom line
As you may suspect, leveraged ETFs are designed for short-term trading activities. The longer you are invested, the more volatile (less predictable) will be your investment outcome.
We wouldn’t necessarily advise you to avoid these products, but be cautious. Leveraged ETFs are complex financial products and should be treated as such. They are powerful tools that allow investors to magnify the returns on investment, but they can amplify losses as well…
Generally speaking, professional investors are the ones who widely use these instruments for hedges or speculative trades in the market. The rebalancing process and costs involved make it incredibly difficult to access what will bring you in returns.
Please find our Online Brokers List if you want to explore platforms that offer leveraged and non-leveraged ETFs. Not in the mood to explore the options by yourself? Just click “Help Me Choose”, and we will give you our best platform for you!
What’s your take on these products after reading our article? Let us know in the comments below!
Franklin is a CFA Level III Candidate with 3 years of experience in Wealth Management as a Fund Research Analyst and the Host of the "Edge Over Hedge" YouTube Channel.
