A Smart Guide To Investing In 3X Etfs

Triple-leveraged exchange-traded funds (ETFs) are a unique breed of investment instruments that seek to amplify returns by a factor of three compared to the index or sector they track. While this may sound enticing, 3x ETFs are not suitable for long-term investing due to their high level of risk and complex structure. These funds are designed for short-term gains and can result in substantial losses over time due to compounding, high expense ratios, and the constant leverage trap. Before investing in 3x ETFs, it is crucial to understand their construction, potential risks, and how they differ from traditional investments.

How to Invest in 3x ETF

Understanding 3x ETFs

3x exchange-traded funds (ETFs) are a unique type of investment instrument that aims to amplify returns by a factor of three compared to the index or sector they track. This means that for every 1% increase in the index, a 3x ETF will aim to return 3%. However, it's important to note that this also applies to losses, so a 1% decrease in the index would result in a 3% loss for the 3x ETF.

While the prospect of tripled returns is enticing, 3x ETFs are not without their risks. They are considered to be much riskier than traditional ETFs and are not suitable for long-term investing. This is because they utilise more leverage, which can lead to higher returns but also increases the potential for significant losses. The use of derivatives, such as futures contracts, swaps, or options, introduces additional layers of risk, including market, counterparty, liquidity, and interconnection risks.

Compounding can also have a significant impact on 3x ETFs. Due to the nature of compounding, where earnings are reinvested to generate additional returns, leveraged ETFs can experience unexpected gains or losses. For example, if the underlying index of a 3x ETF increases by 5% one day and then decreases by 5% the next, the ETF will go up 15% and then down 15% on consecutive days. This results in a net loss for investors even though the underlying index's net change was zero.

Another important consideration is the daily reset of 3x ETFs. Unlike traditional margin accounts, leveraged ETFs reset to their underlying benchmark index on a daily basis to maintain a fixed leverage ratio. This can lead to a situation known as the constant leverage trap, where the price of a security eventually declines significantly, causing substantial losses for highly leveraged investors.

Additionally, 3x ETFs tend to have high expense ratios, which can erode returns over time. These expense ratios, which cover the fund's annual operating expenses, are often around 1% for triple-leveraged ETFs, compared to under 0.05% for standard stock market index ETFs.

Overall, 3x ETFs are complex investment vehicles that are not suitable for all investors. They are best suited for short-term traders looking to capitalise on daily market movements and who have a high tolerance for risk. It is crucial for investors to thoroughly understand the risks and potential consequences before investing in 3x ETFs.

Compounding and volatility

When it comes to compounding in 3x ETFs, the effects can be surprising. For example, consider an investor who invests $100 in a 3x ETF. If the underlying index increases by 5% on one day and then decreases by 5% on the next, the 3x ETF will reflect these changes with a 15% increase and a subsequent 15% decrease. As a result, the initial $100 investment would be worth $97.75, representing a loss of 2.25% even though the underlying index's net change was zero. This example demonstrates how the compounding effect can work against investors in 3x ETFs, leading to unexpected losses.

Volatility in the underlying index or asset can also have a significant impact on 3x ETFs. During periods of high volatility, the frequent fluctuations in value can lead to "volatility decay," where the 3x ETF's performance deviates from what would be expected in a linear growth model. This can result in unexpectedly large losses for investors, even when the underlying index ends close to its original value. For instance, during a period of high volatility in the Technology Select Sector Index (IXTTR) between mid-December 2008 and mid-April 2009, the 3x Bull ETF gained only 9.94%, much less than 3x the benchmark's return.

The combination of compounding and volatility can further exacerbate the risks associated with 3x ETFs. In volatile markets, compounding can lead to permanent losses, as seen during the first half of 2020 when the ProShares Ultra S&P 500 (SSO), a 3x leveraged ETF, lost 40% of its value in just three months. This highlights the critical nature of volatility and compounding in understanding the risks of investing in 3x ETFs.

It is important to note that 3x ETFs are designed for short-term trading and are not suitable for long-term investing due to the risks associated with compounding and volatility. These investments require active monitoring and management and are intended only for sophisticated investors who understand leverage risk and can dedicate the necessary time and resources to track their positions closely.

Derivatives

3x ETFs get their leverage by using derivatives, which introduce another set of risks. Derivatives are essentially agreements whose values depend on the prices of underlying financial assets. These instruments introduce multiple layers of risk, including market, counterparty, liquidity, and interconnection risks. When you invest in 3x ETFs, you're indirectly exposed to all these risks.

Many 3x ETFs rely on derivatives such as futures contracts, swaps, or options to track their underlying benchmarks. A 3x ETF's derivatives are typically a large amount of cash invested in short-term securities and a smaller but highly volatile portfolio of derivatives. The cash is used to meet any financial obligations that arise from losses on the derivatives.

The derivatives most commonly used by 3x ETFs are index futures, equity swaps, and index options. Index futures are a type of derivative contract that allows investors to speculate on the future value of an underlying index. Equity swaps involve the exchange of cash flows between two parties based on the performance of a stock or collection of stocks. Index options give the holder the right, but not the obligation, to buy or sell the underlying index at a specified price by a certain date.

Leveraged ETFs, such as 3x ETFs, respond to share creation and redemption by increasing or reducing their exposure to the underlying index using derivatives. The constant rebalancing of leveraged ETFs creates higher costs, which eat into investors' returns.

For example, let's say a 3x ETF fund has $100 million in assets and $200 million in index exposure. If the index rises by 1% on the first day of trading, the fund will make $2 million in profits (assuming no expenses). The fund now has $102 million in assets and must increase its index exposure to $204 million to maintain its leverage ratio. This constant adjustment, known as rebalancing, allows the fund to provide triple the exposure to the index at any given time.

Daily resets and constant leverage trap

Daily Resets and the Constant Leverage Trap

One of the most significant differences between traditional margin accounts and leveraged ETFs is the daily reset. Unlike margin accounts, leveraged ETFs reset to their underlying benchmark index on a daily basis to maintain a fixed leverage ratio. This seemingly minor detail has profound implications and leads to what is known as the constant leverage trap.

The constant leverage trap refers to the tendency of leveraged ETFs to lose far more of their value than expected in volatile markets due to their daily reset. For example, if a 3x Dow ETF had existed during the infamous Black Monday in 1987 when the Dow Jones plummeted by about 22% in one day, it would have lost about two-thirds of its value. This highlights the catastrophic risk these ETFs carry in the face of severe market downturns.

Given enough time, a security's price will inevitably decline substantially, and highly leveraged investors can be wiped out. The short and fierce bear market in early 2020 is a stark reminder of this risk.

The constant leverage trap also applies to inverse (-1X) ETFs. The daily reset on single-exposure inverse funds results in the unexpected decay of returns, although the effect is less pronounced compared to larger leverage factors.

In addition to the constant leverage trap, triple-leveraged ETFs also carry other risks and drawbacks. They have very high expense ratios, typically around 1% per year, which erode returns over time and make them unattractive for long-term investors.

The allure of 3x ETFs lies in the potential for multiplied returns, but it is essential to understand the complex web of risks that can catch investors off guard. These investment vehicles are not suitable for the faint of heart or long-term investors. They are best left to those who thoroughly understand the intricacies of leveraged trading and have a high tolerance for risk.

High expense ratios

Expense ratios are an important consideration when investing in 3x ETFs. While they may seem like a minor detail, they can significantly impact your returns over time. Triple-leveraged ETFs tend to have high expense ratios, which make them unattractive for long-term investors. These expense ratios cover the fund's total annual operating expenses and are usually expressed as a percentage of the fund's average net assets. Even a small difference in expense ratios can result in substantial losses for investors over the long term.

Triple-leveraged ETFs often charge around 1% per year in expense ratios. For example, the ProShares UltraPro QQQ (TQQQ), which aims to triple the daily returns of the Nasdaq 100, has a gross expense ratio of 0.98%. In contrast, typical stock market index ETFs have much lower expense ratios. For instance, the Invesco QQQ (QQQ), which tracks the Nasdaq 100 without leverage, has an expense ratio of just 0.20%.

When investing in 3x ETFs, it's important to consider the impact of the high expense ratios on your returns. For example, a 1% annual loss in expense ratios can amount to over a 26% loss over 30 years. Therefore, while 3x ETFs offer the potential for higher returns, they also come with higher fees that can eat away at those returns over time.

Additionally, it's worth noting that even the ETFs with the highest expense ratios in the industry still have expense ratios below the average for traditional actively-managed mutual funds, which is around 1.4%. However, when investing, it is always important to consider all costs and fees associated with a fund to make an informed decision.

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