However, 3x exchange-traded funds (ETFs) are especially risky because they utilize more leverage in an attempt to achieve higher returns. Leveraged ETFs may be useful for short-term trading purposes, but they have significant risks in the long run.
For example, suppose a 3x levered ETF is initially offered at $100/share. Even if the underlying declined by more than 33%, the ETF price would not be zero, because it rebalances daily. What happens when a leveraged ETF goes to zero? Most never will, so the point is moot.
Leveraged 3X ETFs are funds that track a wide variety of asset classes, such as stocks, bonds and commodity futures, and apply leverage in order to gain three times the daily or monthly return of the respective underlying index.
Leveraged ETFs decay due to the compounding effect of daily returns, volatility of the market and the cost of leverage. The volatility drag of leveraged ETFs means that losses in the ETF can be magnified over time and they are not suitable for long-term investments.
Because leveraged single-stock ETFs in particular amplify the effect of price movements of the underlying individual stocks, investors holding these funds will experience even greater volatility and risk than investors who hold the underlying stock itself.
A firm that operates with both high operating and financial leverage can be a risky investment. High operating leverage implies that a firm is making few sales but with high margins. This can pose significant risks if a firm incorrectly forecasts future sales.
A trader can hold the majority of these ETFs including TQQQ, FAS, TNA, SPXL, ERX, SOXL, TECL, USLV, EDC, and YINN for 150-250 days before suffering a 5% underperformance although a few, like NUGT, JNUG, UGAZ, UWT, and LABU are more volatile and suffer a 5% underperformance in less than 130 days and, in the case of JNUG ...
As with the first example above, a triple-leveraged S&P 500 ETF loses 60% when the underlying index only loses 20%. In some rare cases, particularly when derivatives are used, a leveraged ETF can even lose all or most of its value.
However, because of the structure of leveraged ETFs, the recommended holding period is from intraday to only a few days. Moreover, if the index drops, the TQQQ will lose 3x as much as the QQQ. Therefore, TQQQ may be better suited for day traders or swing traders.
It should be noted that the SQQQ and TQQQ ETFs are prone to time decay because they are made up of financial derivatives.
A company is said to be overleveraged when it has too much debt, impeding its ability to make principal and interest payments and to cover operating expenses.
3x leveraged ETFs look to generate three times the returns of the underlying index. This also means 3x leveraged ETFs also will generate losses that are three times that of the index. It's also key to know that the return is expected on the daily return, not the annual return.
Thus, if a margin trader uses 100 times the leverage, their risk and possible profit can be increased by 100 times. Leverage is a powerful tool for traders. You can use it to benefit from relatively small price fluctuations, provide larger position sizes for your portfolio, and grow your capital more quickly.
Yes, leveraged ETFs can go negative in value. However, it's essential to understand the mechanisms behind leveraged ETFs and how they can lead to negative returns. Leveraged ETFs aim to deliver a multiple (2x or 3x) of the daily returns of an underlying index or benchmark.
Using leverage is another technique that professional investors may use to provide greater potential for profit. It can also result in greater losses, although typically not more than you put in. In essence, leveraging allows you to use borrowed money to invest a greater amount and therefore amplify your results.
Overall SSO has the least amount of decay, averaging -0.004% daily since inception while TQQQ averages -0.027% daily, a whopping seven-fold that of SSO. QLD was in between and averaged -0.013% decay daily.
The reason is simple: despite the warning, many retail investors have been making long-term buy and hold investments in TQQQ and other highly leveraged ETFs at least since 2019.
5-Year Holding Period: Worse Performance Than 1-Year
However, due to the asymmetric effect of magnifying losses more than gains, holding TQQQ for too long can actually have disastrous effects, especially since the longer you hold, the more likely you are to encounter a major protracted bear market.
Cons of TQQQ
Market risk: Leverage funds like TQQQ can see extreme swings in prices, which makes this ETF too risky for investors who have a low tolerance for volatility. Expenses: Most ETFs have expense ratios below 0.20%, whereas the expenses for TQQQ are 0.95%, or $95 for every $10,000 invested.
Because they rebalance daily, leveraged ETFs usually never lose all of their value. They can, however, fall toward zero over time. If a leveraged ETF approaches zero, its manager typically liquidates its assets and pays out all remaining holders in cash.
Using leverage can result in much higher downside risk, sometimes resulting in losses greater than your initial capital investment. On top of that, brokers and contract traders often charge fees, premiums, and margin rates. This means that if you lose on your trade, you'll still be on the hook for extra charges.
Leverage can magnify returns but can also magnify losses and is therefore considered a risky investment strategy that should only be used by professionals. For other investors, there are less risky ways to access leverage returns, one of the best being leveraged exchange-traded funds (ETFs).
Direxion launched its first leveraged ETFs in 2008. In November 2008 the company was the first to offer ETFs with 3X leverage, a move that was copied some months later by its competitors ProShares and Rydex Investments.
Holding too many ETFs in your portfolio introduces inefficiencies that in the long term will have a detrimental impact on the risk/reward profile of your portfolio. For most personal investors, an optimal number of ETFs to hold would be 5 to 10 across asset classes, geographies, and other characteristics.
10+ ETFs is too many for a retail investor.
Having many exchange-traded funds (ETFs) in the portfolio is probably wrong. Increasing the number of ETFs in the portfolio increases the likelihood that some may overlap (i.e., be redundant).