Benjamin Felix December 19, 2014 Advanced Investing Personal Wealth Leveraged ETFs: Not Appropriate for Long-Term Investors If an investor believes in the long-term performance of equity markets, why would they not use leverage to invest in equities, amplifying their long-term returns? Ideally, a leveraged ETF gives investors the opportunity to participate in amplified gains and losses as compared to the market. In theory, if an investor has a long-term belief in markets, it would be expected that holding a leveraged version of the market portfolio would yield amplified long-term gains. However, in practice, this does not hold true for a handful of reasons. Using data on HXU (an S&P/TSX 60 2x daily return ETF), HSU (an S&P 500 2x daily return ETF), XIU (an S&P/TSX 60 index ETF), and SPY (an S&P 500 index ETF), along with some discussion, we will see why leveraged ETFs are not all that a long-term investor might hope for. Psychologically, most investors are not able to handle the massive negative returns that come with leverage. In 2008, HXU returned -62.17% vs. -31.08% for XIU, and HSU returned -63.27% vs. -21.16% in CAD for SPY. The negative returns of the index have been amplified by 200%, and 300% respectively. Due to the sequence of returns being so important in long-term investing, big negative years end up dragging down the performance of leveraged ETFs. Over the last 5 years, performance has been positive for stocks, but leveraged ETFs have not fared as well as would be expected. HXU’s annualized return since its inception on January 8, 2007 has been 1.71% vs. 1.58% for XIU. HSU’s annualized return since its inception on June 18, 2008 has been 7.39% vs. 8.79% in CAD for SPY. Leveraged ETFs claim to offer exposure to 2x the index, but in practice they do not deliver. The following chart compares some past returns: Where we would expect HXU to return 200% of XIU, it only returned 164% and 140% over respective 3 and 5 year periods. HSU returned 160% and 151% of SPY over respective 3 and 5 year periods, again well below the target of 200%. Although these funds are able to multiply losses by 200% and even 300% (as seen in (1.) above), they do not achieve 200% tracking of positive performance. The fees and costs are high: MER (1.46%) + TER (.59%) = 2.05%. You lose the opportunity to rebalance. With a portfolio of stocks and bonds, the bond allocation can be used as a source of cash to buy more equities when equities are down. With a leveraged portfolio in an equity downturn, you’re likely to become under collateralized at some point, requiring rebalancing out of stocks(due to margin calls) when stocks are cheap. The belief that the long-term performance of markets could be amplified using leverage seems logical; the problem is that the execution of this idea leaves much to be desired. Leveraged ETFs are designed for short-term trading, not long-term investing, and their implementation in a long-term equity portfolio is not an appropriate strategy. Share: Facebook Twitter LinkedIn Email IIROC AdvisorReport