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Leveraged ETFs are generally easy to trade, and they provide investors with the opportunity to multiply their gains on the long and short side of a wide variety of market sectors. However, these funds can also be extremely complex and volatile, resulting in four common investing mistakes.
Ignoring how Rebalancing Affects ETFs
Most leveraged funds are rebalanced on a daily basis, which may sound like a lot of bookkeeping, but the process can have a major impact on performance if prices are choppy or are moving against an ETF. For example, an ETF that is leveraged 3x and loses 2% on its index in one day would have an effective loss of 6%. Rebalancing compounds the loss because the fund’s holdings must be adjusted lower to reflect 3x leverage on the closing price of the shares for that day.
In this example, if 100 ETF shares were purchased at $10, the leveraged exposure would be $3,000 (3x the cost of the shares). After a 6% loss, the shares of the ETF would be priced at $9.40. The shares would then be rebalanced to reflect 3x exposure for $9.40, which would reduce the total exposure of the shares to $2,820.
Starting the next day, or several days, with lower exposure as a result of downward rebalancing (also referred to as negative compounding) requires a larger percentage to move higher to break even. The impact on performance due to downward rebalancing is the primary reason why leveraged ETFs tend to work better as short-term trading vehicles, rather than as buy-and-hold investments.
Buying on Margin
Buying leveraged ETFs in margin accounts adds leverage to fund shares that are already structured to provide volatility. For example, if an investor buys $10,000 of a 2x leveraged ETF at a 50% margin, $5,000 would be required to cover the position. Being on margin at 50% effectively doubles the existing leverage on the investor’s $5,000, meaning that price changes on the ETF’s index would be multiplied by 4x.
In this example, a 2% loss on the index would result in an 8% loss (4 x 2%) of the shareholder’s equity. If the losses were to continue, the shareholder’s initial equity in the position would likely be erased after an approximate loss of 25% against the fund’s index. To make matters worse, any losses exceeding 25% could put the position at a negative value, which would have to be covered using other assets in the account or be paid out of pocket.
Allowing Leverage To Overweight Sector Exposure
Asset allocation within a portfolio is typically measured by the dollar value of each sector in the account. However, when sectors include leveraged ETFs, the exposure can be far greater than the value of the positions within the category.
For example, say an investor decides to allocate $20,000 to each of five sectors within a $100,000 portfolio. With the money allocated to commodities, the investor buys a 3x leveraged gold ETF and a 3x leveraged oil ETF. Due to the leverage in the ETFs, this sector of the portfolio would be significa