Leveraged exchange traded Funds (ETFs), such as 3x ETFs, have gained popularity in recent years as tools for aggressive traders looking to amplify returns on short-term market movements. These funds aim to deliver three times the daily performance of an underlying index or asset. For example, if the S&P 500 rises by 1% in a day, a 3x ETF tracking the index would rise by 3%. Conversely, if the index falls by 1%, the 3x ETF would decline by 3%.
While the allure of quick, multiplied returns might seem attractive, many experts caution that 3x ETFs can be horrible investments for long-term investors due to a variety of structural risks and limitations. This article will explore the risks and downsides of 3x ETFs to help investors understand why they may not be suitable for most portfolios.
Understanding the Mechanics of a 3x ETF
A 3x ETF uses derivatives like futures contracts, options, and swaps to magnify the daily returns of an underlying asset or index. If an investor expects a short-term bullish move in the market, they may use a 3x long ETF to amplify gains. On the other hand, investors expecting a market decline may choose a 3x inverse ETF to capitalize on falling prices.
While this strategy can work well for short-term traders with precise timing, the daily rebalancing of these funds introduces significant challenges, particularly for those who hold them for extended periods.
Potential for High Losses
The most obvious risk of a 3x etf is the potential for amplified losses. Just as gains are magnified when the underlying index moves in the desired direction, losses are similarly multiplied when the index moves against the investor’s position.
For example, if an index falls by 1%, a 3x ETF will experience a 3% decline. This compounding effect can result in devastating losses during periods of market volatility or sustained downward trends. The risk of losing capital quickly is considerably higher with a 3x ETF compared to standard ETFs.
Volatility Decay and Compounding Risk
One of the primary reasons why 3x ETFs are considered poor long-term investments is due to a phenomenon known as volatility decay (or compounding risk). Because 3x ETFs reset daily, their performance over time can deviate significantly from the expected three-times multiple of the underlying index’s long-term returns.
The compounding effect becomes particularly problematic during periods of high volatility, where frequent fluctuations in the underlying index reduce the ETF’s value over time. This happens because daily percentage losses and gains do not offset each other symmetrically. For instance, if the ETF loses 10% one day and gains 10% the next day, the net value of the ETF will be lower than it was at the start.
Here’s an example:
- Day 1: The index rises by 1%. The 3x ETF rises by 3%.
- Day 2: The index falls by 1%. The 3x ETF falls by 3%.
After two days, the index is back to its starting point, but the 3x ETF is down by 0.09% due to the impact of compounding. Over time, this compounding leads to erosion of value, making 3x ETFs underperform significantly, especially during volatile or sideways markets.
Not Suitable for Long-Term Investing
Many investors mistakenly assume that a 3x ETF will deliver three times the long-term performance of the underlying index. However, these funds are designed specifically to track daily movements and are not built for long-term holding.
Due to volatility decay and the rebalancing process, the performance of a 3x ETF can diverge dramatically from the index over longer periods. For example, if the S&P 500 increases by 10% over a year, a 3x ETF might not deliver a 30% return, especially in volatile market conditions. In fact, the return could be significantly lower, or even negative, depending on the volatility and direction of the market.
Increased Fees and Costs
3x ETFs tend to have higher management fees than traditional ETFs due to the complexity of their structure and the costs associated with the derivatives used to achieve leverage. The expense ratios of 3x ETFs can be several times higher than those of non-leveraged ETFs. For example, a typical broad-market ETF may have an expense ratio of around 0.03% to 0.1%, whereas a 3x ETF can charge anywhere from 0.95% to 1.5%.
Additionally, the fund’s frequent rebalancing generates higher transaction costs, which further eat into potential returns. Over time, these fees compound, making it even more difficult for a 3x ETF to deliver satisfactory returns, particularly for long-term holders.
Market Timing Challenges
Successful use of a 3x ETF requires accurate market timing. Investors must not only predict the direction of the market but also the magnitude and timing of its movements. Since the leverage resets daily, investors need to closely monitor market conditions and make timely adjustments to their positions.
Even professional traders, with access to sophisticated tools and insights, often find it difficult to consistently time the market. For retail investors, the challenges are even greater, increasing the likelihood of losses when trying to use 3x ETFs over any significant period.
Exposure to Short-Term Volatility
3x ETFs are particularly vulnerable to short-term volatility. In highly volatile markets, the compounding of daily returns can result in unpredictable performance. For example, during periods of large daily price swings in either direction, the 3x ETF may fail to track its underlying index effectively and could lose significant value.
Moreover, these funds are highly sensitive to news events and market shocks. A sudden market downturn or unexpected news can lead to sharp declines, potentially resulting in large, rapid losses for investors holding 3x ETFs.
Liquidity and Bid-Ask Spreads
Another risk associated with 3x ETFs is liquidity. While the most popular 3x ETFs generally have sufficient liquidity for retail traders, smaller or niche leveraged funds may face liquidity constraints, especially during periods of market stress. Lower liquidity can lead to wider bid-ask spreads, meaning that investors may incur additional costs when entering or exiting positions.
In times of extreme market volatility, the liquidity of 3x ETFs may also diminish, making it harder for investors to execute trades at desired prices, further compounding losses.
Risk of Leverage Decay in Trending Markets
Even in trending markets, 3x ETFs can underperform over time due to leverage decay. If a market trend is consistent but not extreme in either direction, the 3x ETF can still lose value as daily rebalancing and market fluctuations erode its returns. Investors who expect a steady rise or fall in the market may find that the 3x ETF fails to provide the anticipated return after factoring in the impact of leverage decay.
Conclusion
While 3x ETFs can be useful tools for experienced traders seeking to capitalize on short-term market movements, they are generally horrible investments for most long-term investors due to several inherent risks. The combination of volatility decay, amplified losses, increased fees, and the difficulty of market timing make 3x ETFs highly unsuitable for those looking for long-term capital appreciation or risk-adjusted returns.
For investors seeking long-term growth, non-leveraged ETFs or other diversified investment vehicles typically offer better risk-reward profiles. Anyone considering a 3x ETF should fully understand its risks, limit their exposure, and use it only for short-term, speculative trading, rather than as a core component of their portfolio.