Financial Opportunities Uncovered: A Keeler & Nadler Family Wealth Podcast

Amplifying gains or amplifying losses? The truth about leveraged ETFs

• Andy Keeler

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Are you curious about leveraged ETFs (exchange-traded funds) and their potential to amplify returns? Or amplify your risks?  Andy and Mark delve into the mechanics of these financial products, breaking down how they aim to provide returns that are two or three times that of indices like the S&P 500 and NASDAQ.   Sounds attractive, right?  However, we uncover the hidden risks and complexities that are typically overlooked.

Join us as we explain how leveraged ETFs operate, clarify common misconceptions around their performance, particularly the idea that gains and losses are consistently multiplied. The reality is this — volatility can lead to unexpected outcomes, making these investments riskier than many believe.

Andy and Mark also discuss investor psychology and how turbulent market conditions can affect decision-making. If you're an investor considering leapfrogging into leveraged ETFs, this episode is a vital resource.  It equips you with the knowledge to make informed choices.  So listen, gain valuable insights, and explore whether leveraging is a fitting strategy for your investing journey.    Don't forget to subscribe, share, and leave a review!


The opinions expressed in this program are for general informational purposes only and are not intended to provide specific advice or recommendations.

It is only intended to provide education about finance, tax, retirement and related planning topics. To determine which investments or strategies may be appropriate for you, consult your financial, tax or legal advisor prior to implementing. Any past performance discussed during this program is no guarantee of future results.

Any indices referenced for comparison are unmanaged and cannot be invested into directly. As always please remember investing involves risk and possible loss of principal capital; please seek advice from a licensed professional.

Keeler & Nadler Family Wealth is a registered investment adviser. Advisory services are only offered to clients or prospective clients where Keeler & Nadler Family Wealth and its representatives are properly licensed or exempt from licensure. No advice may be rendered by Keeler & Nadler Family Wealth unless a client service agreement is in place.


Andy Keeler :

Ever heard of a leveraged ETF? These complex products promise two or even three times, maybe even more, the return of an index. What's not to like about that? Imagine the NASDAQ goes up 10 or 20% in a year and the leveraged ETF tracking the NASDAQ goes up by 30 or even 60 percent, or does it? One of our regulars, Mark Beaver, joins us to dissect these gizmos. How's it going, Mark? Good, 20 episodes in. Pretty cool. That's pretty good, for I don't know when we started this thing, but not even a year ago. So doing okay, I guess. Now we just need to get people to listen. So these leveraged ETFs, how do they work?

Mark Beaver:

So, leverage in our world basically means using some instruments, particularly in this case options contracts, to magnify the results of something you know. So you could use options in a way to where you wanted to buy an investment but you didn't have enough to buy as much as you wanted. So you leverage that up to get exposed more to it because of that option. So it kind of magnifies the outcomes of what can happen in both a good direction or potentially a bad direction. Kind of like margin can be. Yeah, so in these leveraged ETFs, exchange traded funds, they're picking typically an index. So the ones you see them the most S&P 500, the NASDAQ.

Andy Keeler :

Okay.

Mark Beaver:

And they're going to say your outcome is going to be 2X or 3X what that index does, so they can contract these different options contracts around those indexes to get that known outcome, whatever it ends up being, because of the options they employ there. And one thing that's important you know with that is they're doing that every day. Those option contracts expire at the end of the trading day. They have to do it again the next day and the next day and the next day. So basically you know, if the market goes up one and a half percent that day, you should be up four and a half percent if you're in a triple levered version of that index that day.

Andy Keeler :

So the index goes up 10,. You should be up, say, 30 if it's a three X.

Mark Beaver:

Yeah, now there's a cost to doing that too. You know they have to pay something for those options contracts, so you do have to net that out of that result or, if it's a loss, kind of add it to the loss, more or less.

Andy Keeler :

And they're like what? 1%, 97 basis points, 90 basis points?.

Mark Beaver:

Yeah, A lot of the popular ones are somewhere around that. It can change depending on what the market does. If those contracts get more expensive, then it could fluctuate a little bit. But that seems to be the normal range.

Andy Keeler :

But let's say it's a 0.9 expense ratio 90 basis points. That's for a year. So it's not like if the let's say, the index goes up 10, in theory the leveraged ETF goes up 30 in that day. It's not like you're getting 29.1, only 29.1%.

Mark Beaver:

You're getting more than that.

Andy Keeler :

And so the index then goes down 10%. How much does the ETF go down?

Mark Beaver:

Yeah, as much as it can go up is the same it can go down. So it's leveraging you up, it's leveraging you down. It's really just magnifying the direction that you're going on a daily basis. And that's where things can get a little bit weird, because it's a daily contract, like in your example. Say, the S&P 500 goes up 10% in a year. You think, okay, I'm in a triple levered S&P fund, it should be 30%. Right, but it didn't just happen. The S&P didn't just go from one place to 10% higher. It went up, it went down, it did different things throughout that and during that period of volatility it can have a different experience with that leverage.

Mark Beaver:

There's a phrase a lot of folks refer to in these leverage ETFs called decay, and it's basically pointing out that when you lose an investment, the farther you decline, the more you need that return to break back even again. So if you lose 10% of your investment, you got to have about 11% rate of return to get back to zero. But if that gets further and further of a loss, it's magnitudes higher of a gain you need to get. So in some of these cases where there's extreme swings to the downside throughout that period, it's going to make that experience even more of a drag for the leveraged ETF, that experience even more of a drag for the leveraged ETF.

Mark Beaver:

So an example of that it could be let's say you started with $1,000 investment and just kind of the regular investment versus the leverage, and that $1,000, that index goes up 10%. So in a normal case your $1,000 is worth $1,100. And the leverage example it goes up to $1,300 because it went up 30%. The next period it goes down 10%. So case one, $1,100 goes down to $990. And the other case, the $1,300, goes down 30%. So it goes down to $910. So when you look back to that original $1,000 investment, the non-lovered experienced about a 1% loss. Overall went from $1,000 down to $9.90, a $10 loss.

Mark Beaver:

The other one went down $90, a 9% loss. So it wasn't three times the loss, it's nine times the loss.

Andy Keeler :

So if you were to say your gains are magnified, your losses are magnified, your gains are magnified by three times, your losses may be magnified by, in your example, nine times, and you would have been in a really good position had you bought one of these in 2009, 2011. Seems like a pretty risky bet to be making, as the market's breaking records.

Mark Beaver:

Absolutely. When you look back at if you bought this at, you know, coming out of the great financial crisis I mean just about any stock related investment was a good one then, but a lot of them launched at a really good time.

Mark Beaver:

You know in that period, like you said, there was a couple of down markets no 50% drawdowns like '08, no 50% drawdown like 2000 to 2002. We really just had that one month in 2020 when the world shut down for COVID.

Mark Beaver:

So, for example, in that case, 2020, I'm just looking at an example from one of the triple-levered S&P funds. It was up 10% in 2020. The S&P was up almost 20%, I think, that year. So you're seeing that lag to where where, yes, it was positive but it actually underperformed the index because it dropped 20% in that month and it had to really recover, even though probably the last three quarters of that year it blew away the S&P, but it had to dig out of that hole. That's where the test we haven't seen on these yet is if we see a 30, 40, 50% decline which you know, God forbid. I hope we don't see anything like that soon, but it can happen and will in our lifetimes. What would that do to these? Because you think about 30 or 40 or 50% loss in the S&P, triple levered means a lot. You know some of these could potentially be down 70%, 80%, 90% in a year like that. A 90% decline, your return to get back even is 900%.

Andy Keeler :

You have to earn 900% on an investment that has recently lost 90% to get back to where you were before the loss, right?

Mark Beaver:

And that could, in those scenarios like a great financial crisis, that's what would have happened, you know, if the underlying index is down 50 percent and you're three times that, you know. I can't give you an exact number, obviously, but it's going to be bad, you know. So you have to recover quite a bit to get out of that hole.

Andy Keeler :

Looking back, these things have been good because that hasn't happened. So the question might come up, Well, looking at a 10-year period of time, let's say the S&P went up 10, these went up 20. Just as an example, they didn't go up 30. They went up 20 because of the decay and the volatility. The first thing I would say is, if you think you're going to get three times, you're not. You're probably not because of the decay. Don't expect three times. Expect maybe two. That's what we've seen over the last 10 years in a pretty good, robust bull market. So someone could say, I'm a firm believer in equities for the long term, I have a 30-year time horizon, so why not roll the dice and invest in something like this? I guess how would you answer that question to an investor or a client that's asking that question?

Mark Beaver:

Just like anything else. You know we always want to come to an investment open-minded and I know our industry can be pretty closed-minded to certain things and this is probably one of those areas that most of our industry is pretty closed-minded on, partially because for compliance and regulatory reasons they're not even allowed to recommend something like this. So it's okay, that's off the table. The scenario you're describing of, hey, I'm a long-term investor, I'm not going to sell anything for 10 plus years, just historically and statistically speaking, it probably does work in a case like that and you described, you know, if the S&P is averaging 10, you're probably not going to average 30 because of decay and you know different factors there. But even if it was 20, that's not just two times the result over 10 years because of the compounding effect of that. We talked about that in another podcast. So, looking back at the last 10 years of this triple levered S&P example, it averaged about 23% or 24% for the last 10 years. So again, not three times kind of the return, but the result is more than that. It's actually five times the results because of the compounding nature of that return. So again, that's a hindsight scenario, not saying future results are going to be that by any means. But that can work if you hold it.

Mark Beaver:

The problem is, I think, backing up to say can you actually execute that? It sounds great. Hey, I'm going to get three times the return of the market, no problem, I can do that. And then we run into that period, like you said, where the market drops 30% and you're down 80, 90%. I don't know that you're going to feel too good about sticking with that. You know so.

Mark Beaver:

Investor behavior is a really important thing and, as good as we all think that we are at behaving and investing properly, we all think we're better than average drivers, which you know can't be the case. You know so. Everybody can't be an above average investor. That just doesn't make any sense. So I think that it takes what your behavior is otherwise and magnifies that too. You know so. If you got nervous when the S&P dropped 10% in a quarter or 20% in a year, just wait until it's three times that amount and see if you can stay with that for a decade. Um, cause, that's certainly going to happen. We've talked about how, on average in any given year, the S&P drops 14%.

Mark Beaver:

That's the average. So again, think of three times. That amount was at 52% on average. You should see a 52% decline in your investment. That doesn't really work as well as you think. It's going to as far as sticking with that for decades at a time. So certainly, certainly kind of. Again, like we said with crypto, if somebody wanted to employ this, it's not going to be a major position, I don't think because of that in your portfolio, but it could work, you know. So I'd say it could. It's just I have my doubts on most people's ability to stick with that over the required period to make it work.

Andy Keeler :

At the beginning you were describing how this is essentially a basket of options that they use to amplify the returns in the market. There are other products out there. Some of them are inverse ETFs. How do those work?

Mark Beaver:

It's magnifying it just in the opposite direction. So they're they're same thing, doing daily options contracts, um, but if you thought that something was going to go down in value, you could bet on it going down, and that inverse is a positive, you know. So I think the price of oil is going to tank, so I'm going to buy an inverse ETF based on oil futures, because I want that exist. It does, yeah, and I think there's leveraged versions of that too, which have fun with that. So, yeah, that one's different, where you know you're betting on something going down to benefit. That's even more dangerous, because things can go up an infinite amount. Things can only go down 100%. You can only lose all of your investment, but things can go up an infinite amount of money. When you start basically shorting something, which is what these inverse ETFs are doing, the loss is exponential.

Andy Keeler :

Some of the articles that I've read on these leveraged ETFs more or less suggest that leveraged ETFs are more appropriate for short-term trading, the way that you described how they're built. These contracts expire at the end of every day, so maybe I'm being a birdbrain here, but it would seem like those options contracts. It's not like you're trying to predict the earnings of NVIDIA 20 years out, which is what you're doing. When you're buying a stock, you're paying a price based on future earnings. Here it's a very short timeframe, so one would think that the number of outcomes would be more limited than someone that's investing in these things for 10 or 20 years. How would you address that?

Mark Beaver:

That's definitely the way they were designed originally was a tool for traders that are doing more higher frequency trading and portfolios to hedge against certain things, upward or downward, you know, hence having inverse and non-inverse ETFs. But they were meant, yeah, for very short term hedging positions. Then it just sort of caught on a little bit as a craze or, you know, almost like the meme stocks that the general public caught on to to say, oh, I'll just get triple the return, and when you see the performance in the recent years work, then that's kind of all the proof you need and so you move on and just do it. B ut again never having to really experience one of those bigger market shocks, like we said, which would disrupt that thesis. But, yeah, they are really not designed to be a long-term hold position from the get-go. Another, maybe more extreme, example of one of these triple-levered was the triple-levered NASDAQ fund. Nasdaq's got a little bit more volatility even than the S&P, so it's a little bit more. In 2022, that fund was down, I think, around 75%.

Andy Keeler :

For the year.

Mark Beaver:

Yeah, because the NASDAQ was down 30-something percent that year, so pretty extreme, and that's not even as worse as it could have been. That's not a good year, but it could have been a lot worse than that and so ultimately it still ended up in a decent spot over a 10-year period because the NASDAQ has recovered the last two years. So it's made up that ground. But you think about that where you had $100,000 in this thing and you lost 75,000 of your 100,000 in a year.

Andy Keeler :

That isn't going to sit well with you. 2022 was just a few years ago, and earlier you were talking about a 90, I think. You said a 90% loss required a 900% return, something like that. So one would think a 70% loss would require a large return. Let's say it's 70%. So you said that it's made up ground since then. I guess the question is did you get back to where you were before that loss, or have you gotten ahead of it? Had you invested in the S&P, you'd be in a really good place because you didn't have that loss and we've had two and a half, three really good years since then. So you would have actually been better off in a non-leveraged standard S&P index or or NASDAQ fund, um, than in the leveraged fund. So I'm putting you on the spot there.

Mark Beaver:

But the triple NASDAQ fund. I just brought it up here. It's actually it was actually down 79% in 2022. The following year it was up 198%, so that will help dig yourself out of a hole, And then last year it was up, uh, almost another 60%, so, but that's 60% on top of the 200% before it. Right right, so it's not quite exactly to where it was before, but it's pretty close. So it did a lot of work there. But that's two in the S&P's standpoint, two 20-plus percent S&P years in a row, sort of bailing that out, which you can't really bank on that happening.

Andy Keeler :

Right, I guess what I'm getting at is because of that severe loss in the triple leveraged NASDAQ ETF. It hasn't even gotten back to where quite where it was before the loss, but had you invested in the S&P you'd be well above where you were.

Mark Beaver:

Yeah, yeah, the three-year return for that's negative 0.4% on it. So averaging that over three years, the S&P is about 10.

Andy Keeler :

Yeah, the point in all this is you got to really be careful and know the limitations, know the risks and, as my mom used to say, she used to dabble in stocks and she said never invest in anything you really don't understand. And I think most people don't really understand the shortcomings of these things. Thanks for the headache, Mark, and, as always, we thank our listeners. Be sure to tune in next time when Mark and I talk about the similarities between health and wealth, fitness and money. I'm Andy Keeler, and this is Financial Opportunities Uncovered brought to you by Keeler and Nadler Family Wealth. If you have questions on anything you heard in this episode, find out more on our website, keelernadlercom, and if you have an idea for a future episode or questions about what you've heard, connect with us on LinkedIn.

Mark Beaver:

The opinions expressed in this program are for general information purposes only and are not intended to provide specific advice or recommendations. It is only intended to provide education about finance tax, retirement and related planning topics. To determine which investment strategies are appropriate for you, consult your finance tax, retirement and related planning topics. To determine which investment strategies are appropriate for you, consult your finance, tax or legal advisor. Prior to implementing Any past performance discussed during this program is no guarantee of future results. Any indices referenced for comparison are unmanaged and cannot be invested into directly. As always, please remember, investing involves risk and possible loss of principle. Please seek advice from a licensed professional. Keeler Adler Family Wealth is a registered investment advisor. Advisory services are only offered to clients or prospective clients where Keeler and Nadler Family Wealth and its representatives are property licensed or exempt from licensure. No advice may be rendered by Keeler and Nadler Family Wealth unless a client service agreement is in place. Thank you.