Can Leveraged ETFs be used as Part of a Buy and Hold Strategy?

Exchange Traded Funds are one of the most revolutionary investment vehicles to come around since they were adopted in the United States markets in 1993. ETFs allow individual investors to track indexes, such as the S&P 500, the DJIA or the Russell 2000, as well as track certain sectors of the market such as financials, telecom, healthcare, retail etc. ETFs can also track commodities like gold, and coffee and crude oil. With over 1500 ETFs available in the US, there is one for just about everyone and anyone. Unlike mutual funds, which have significantly higher management fees, ETFs trade like stocks so they can be bought and sold intraday.

More recently, leveraged ETFs have been introduced into US markets. Leveraged ETF’s are a relatively new type of security in which the ETF seeks to double or triple the movement of the underlying index or product. These modern vehicles do so by using financial derivatives and debt to amplify the returns of the underlying asset. This allows investors to double or triple their potential reward as well as potential risk.

If you Google “Leveraged ETF”, you are likely to come across headlines warning you of the inherent riskiness beyond just the 2x or 3x leverage the ETF offers. These warnings have some merit, but it’s important to realize that if used wisely, these investments can be used to generate large returns with small amounts of money.

I’ll break down leveraged ETF’s so you don’t end up in the red using these investment instruments.

To simplify things, there are two main types of leveraged ETFs: Those that should primarily be traded on a short-term basis, and those that can be part of a successful long-term portfolio. As a rule of thumb, the more underlying securities or products a leveraged ETF uses, the more likely you may buy and hold it as part of your portfolio.

I’ll give two examples.

A leveraged ETF I do not recommend using as part of a buy and hold portfolio:

SOXL – Daily Semiconductor Bull 3x Shares.

The semiconductor sector is part of the larger technology sector. The tech sector makes up somewhere between 20% and 30% of the US market depending on how you define it. However the semiconductor sector makes up only 4%. This means a few key players can manipulate the underlying instruments used by SOXL such as futures, swaps and option contracts. Over time this can cause the returns of SOXL to deviate greatly from the advertised 3x returns of the PHLX semiconductor sector index.

The math is complicated, but 3x ETFs reset daily and volatility can eat away at long-term returns. With unpredictable returns, the risk/reward parity is thrown off balance. If you look at any single day however, SOXL will generate about 3x the return of the overall semiconductor sector index. So you can use SOXL or something like it successfully, but that strategy would probably include holding the security for a very short period of time.

A leveraged ETF I do recommend using as part of a buy and hold portfolio:

SSO – Ultra S&P500.

This ETF is a 2x leveraged S&P tracking instrument and is highly liquid. Over time, SSO has generally given investors about two times the return of the S&P500 even over the long run. Why? Since the S&P500 is a combination of 500 different large and medium cap stocks, it is all but immune to institutional investor manipulation. Even the largest of investment banks or hedge funds cannot drastically move the price of the entire index by buying or selling individual stocks within it.

Even with broad based leveraged ETFs like SSO, downswings are more difficult to recover from. If you buy both SSO (2x S&P500) and SPY (1x S&P500) at the same time, and the index gets off to a rough start, a recovery might not end up yielding you 2x the gains.

See the chart below, which tracks SSO vs. SPY from 2011 through 2016. Starting with $10,000, SSO has grown to a balance of $24,108. SPY has grown from $10,000 to $17,069. A 141% ROI vs. a 71% ROI respectively. That’s just about as close to 2x the return as you can ask for. Screen Shot 2016-02-20 at 6.39.55 PM

“Portfolio 1 = SSO” – “Portfolio 2 = SPY”

In the second chart, we’re tracking the same ETFs but extending out to 2007 through 2016. In this scenario, SSO has grown to a balance of $14,587, while SPY has grown to $16,488. Even though both portfolios have gone up in equity, SPY actually beats SSO because SSO suffered twice as much from the 2008 crash. SSO had a higher hill to climb once the recovery started. This illustrates why you cannot simply assume that a 2x ETF will always generate 2x the return.

Screen Shot 2016-02-20 at 6.45.19 PM

Still, if you can stomach the additional risk, SSO is a great ETF to use when you have little money to invest and are looking to increase returns without trading on margin. Just know that leveraged ETFs need to be watched more closely than non-leveraged ETFs.

What’s the Takeaway?

Leveraged ETFs should be used with caution, but investors may use certain leveraged ETFs as part of their long-term portfolios. Keep in mind, it’s especially important to do your due diligence before investing with these securities. It would be wise to put a stop loss on these trades because of the substantial increase in volatility. Broadly indexed leveraged ETFs are safer than ones with a narrow scope, but don’t be afraid to use either type so long as you understand there will be swings in your account balance.

-Brian

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