Key Takeaways
-
“2X SPCX” sounds like an enticing proposition until the effects of compounding produce wonky returns.
-
Leveraged ETFs can be useful, but knowing how they work can help investors avoid unintended consequences of buying and holding them.
Amplifying SpaceX’s share-price moves might sound like a sure way to juice returns. It’s not quite that simple.
Nearly a dozen exchange-traded funds that promise to deliver “2X,” or twice, the daily returns of SpaceX (SPCX) launched Monday, per Bloomberg ETF analyst Eric Balchunas. The idea is simple enough: Since the stock rose about 20% today, the ETFs would be up 40%. They, like other popular leveraged funds, borrow to enhance their performance—or they use derivatives, such as futures or options contracts or swaps, to deliver souped-up results. And they have a reputation for being “dangerous”—mainly because investors who use them incautiously can meet with undesirable consequences.
There are three main things to keep in mind about leveraged ETFs, whether they reference SpaceX or some other stock or asset—the multiplier effect means both magnified gains and magnified losses; they experience a mathematical phenomenon that drags down performance over time; and they tend to have higher fees and expenses, which eat into returns.
WHY THIS MATTERS TO YOU
Certain financial terms have negative associations—like “leverage,” which generally refers to using borrowed money to amplify results. Leveraged ETFs, like those that have recently popped up on the back of the SpaceX IPO, can supercharge gains, but only for investors who are both careful and fortunate.
The first point is fairly straightforward: When an ETF promises “2X” daily returns, it means gains and losses. So if an ETF’s reference asset falls 10%, the ETF’s losses can hit 20%. When something is moving in the right direction, that can be good news. And big losses can lead to big problems for investors: A stock that falls 10% in a day needs to rise 11% to get back to par, but the associated leveraged ETF, down 20%, would need to rise 25%.
The second is caused by something called “volatility decay,” which occurs because leveraged ETFs are rebalanced daily. Let’s say that, on a given day, a $100 stock rises 10%, to $110; the corresponding 2X leveraged ETF will rise 20%, to $120. But if, on the next day, the stock falls about 9.1%, back to $100, the leveraged ETF will fall more than 18%, to closer to $98. The longer this effect runs, the more challenged those ETF returns can be. To minimize this effect, it’s generally suggested that an investor not hold a leveraged ETF for more than a few days at a time. (And that, naturally, requires correct bets about which days are the best ones on which to buy and sell.)
That drag happens even when the asset in question is a blue-chip stock that has been gaining. For example, compare the year-to-date return of Apple (AAPL), which has risen about 9%, to that of any 2X leveraged ETF that is referencing it; the latter’s returns won’t be double that.
Finally, as with most investment products, investors should read the fine print. The operating costs of buying and selling derivatives, plus the fees the fund shop charges to run the ETF, are a drag on returns, especially if the underlying asset—and your fund—aren’t logging big gains. These products generally have expenses far higher than do more basic products, such as S&P 500 index funds, and investors should calculate the effect of those expenses on their results.
Read the original article on Investopedia