A 3x ETF magnifies returns, both good and bad, but should you make room for them in your investment portfolio?
At the time of writing the S&P 500 index is up 21.6% so far this year. The SPDR S&P 500 ETF (SPY) is, as you would expect, up 21.87%, about the same as the benchmark returns (which can be attributed to intraday pricing). At the same time, the ProShares Ultra S&P 500 ETF (SSO), which is designed to replicate double the daily performance of the S&P 500, is up 47.2%. Lastly, the Direxion Daily S&P 500 Bull 3X Shares (SPXL), a 3x ETF designed to provide triple the daily returns of the S&P, is up over 76.3%.
If you’ve never traded a leveraged or 3x ETF, you would probably expect SSO to be up only 44% and SPXL to be up only 66% or so. After all, those are double and triple the year-to-date returns, respectively. So why have those investments outperformed expectations?
The answer lies in the way the returns of the investments are calculated. Because both of the leveraged funds compound daily, they increase their leveraged exposure after every up day, and decrease it after every down day. In a strong bull market where indexes are consistently hitting new highs, a 3x ETF will outperform the index because the fund is essentially doubling down on its bets.
By that same token, the Direxion Daily S&P 500 Bear 3X Shares (SPXS), which you might expect to be down 66% (it’s a 3x ETF replicating triple the inverse performance of the S&P) is down only 49.7% this year. The fund is outperforming 3x the inverse of the S&P because each day the S&P trades higher, this fund trades lower which reduces the fund’s leveraged exposure.
The table below offers a more concrete, although obviously hypothetical example:
|Investment||Value||Daily % Change||New Value|
|Index (Day 2)||$90||+11.11%||$99.99|
|3x ETF (Day 2)||$70||+33.33%||$93.33|
If you have a $100 investment in the index after those 2 (extreme even for a hypothetical) days of trading you’ve basically broken even at the end of day 2. On the other hand, a $100 investment in a 3x ETF tracking the same index is now worth only $93.33, a loss of 6.66%.
That’s because the fund reduces your leveraged exposure to the index after a down day, so you have less participation in the subsequent up day.
That example is an oversimplification, but a good representation of what a double or 3x ETF will do during choppy trading, which is one of the worst times to hold these investments.
So, that brings us back to the question posited in the headline, should you buy a 3x ETF?
The answer will vary by investor and market conditions. If you’re working with an otherwise appropriately allocated portfolio and are looking to marginally increase equity or sector exposure due to a strong and persistent uptrend, it’s perfectly reasonable to earmark a small portion of your investments for leveraged funds. The degree of allocation should be based on your own risk tolerance and how leveraged the fund is (a 2x ETF is more forgiving than a 3x ETF if you’re on the wrong side of the trade).
However, you need to approach these leveraged investments as a momentum trader or “swing trader” with a short- to intermediate-term timeframe. These funds are not ideally suited for long-term buy-and-hold traders and are best avoided in retirement accounts where losses cannot be easily replaced by contributions.
If you’re investing in these, you’ll also want to be comfortable with technical analysis because many of the best momentum clues come from chart studies.
Lastly, if you’re interested in learning more about the risks or mechanics of leveraged funds, Direxion, one of the most prominent leveraged and inverse ETF companies, offers educational materials and an “ETF University” to help you better understand the products.
Leveraged funds aren’t a great core holding, and they’re not for everyone, but used appropriately and in moderation, they can provide significant returns.
What leveraged ETFs have you used in your portfolio?