Upro: Why Investors Are Not Buying

Leveraged ETFs like UPRO are risky but potentially high-reward securities if the market moves your way. UPRO is a leveraged ETF that seeks to replicate the daily movements of the S&P 500 multiplied by a factor of three. For example, if the S&P 500 increased by 2% in a day, UPRO's price should increase by six per cent. Conversely, if the S&P 500 were to decrease on a given day, UPRO should decline in price by whatever the percentage decrease of the S&P was, multiplied by a factor of three.

While it isn't always necessarily true that leveraged ETFs underperform in the long run, they are typically used as a short-term tool to speculate on the daily price movements of the S&P 500. This is because of a phenomenon known as volatility drag.

For example, if the S&P 500 drops by 20% one day and recovers by 25% the next, the S&P ends up where it began, but UPRO would have experienced a 60% drop in price, followed by a 75% recovery, ending the two days down 30%.

Another reason people may be discouraged from investing in UPRO is the high expense ratios that come with leveraged ETFs. For example, UPRO has an expense ratio of 0.93, which is quite high compared to VOO at 0.03.

Ultimately, UPRO is a risky investment that is more suitable for experienced investors with a deep understanding of the security and the risk tolerance to endure the volatility that high leverage brings.

Volatility decay

For example, if an index gains 3% one day and loses 7% the next, ending the week flat, a triple-leveraged ETF will experience amplified movements, resulting in a net loss over the week. This is true even if the triple-leveraged ETF perfectly amplifies the index's daily movements.

The impact of volatility decay is more pronounced when considering the downside risk. If a normal index loses 34%, an investor still has 66% of their portfolio value left for future recovery. However, a triple-leveraged product will be completely wiped out.

In conclusion, while leveraged ETFs may sound appealing, volatility decay can significantly affect their performance. Even for long-term investors who are certain that "stocks only go up," it is generally better to invest in the index fund itself rather than its leveraged counterpart.

High expense ratios

Leveraged ETFs like UPRO are known for their high expense ratios. The ProShares UltraPro QQQ (TQQQ), which seeks to triple the daily returns of the Nasdaq 100, has a gross expense ratio of 0.98%. Compare that with typical stock market index ETFs, which usually have low expense ratios. For example, the Invesco QQQ (QQQ), which is not leveraged and tracks the same index as the TQQQ, has an expense ratio of 0.20%. UPRO has an expense ratio of 0.93%, which is quite high compared to VOO at 0.03%.

The reason for such a high expense ratio is that leveraged ETFs incur significant fees from daily rebalancing and interest and transaction fees. Even a small difference in expense ratios can cost investors a substantial amount of money in the long run. Triple-leveraged ETFs often charge around 1% per year.

Over time, their value will tend to decay even if the underlying price movements are favourable. This is due to a phenomenon called volatility decay. Volatility decay refers to the tendency of leveraged ETFs to underperform their underlying index over time due to the effects of compounding and the daily rebalancing of the ETF to maintain its target leverage ratio.

For example, consider a scenario where the S&P 500 drops by 20% one day and then recovers by 25% the next day. In this case, the S&P 500 ends up where it started (0.8 x 1.25 = 1), but UPRO would have experienced a 60% drop in price, followed by a 75% recovery, ending the two days down 30% (0.4 x 1.75 = 0.7).

While leveraged ETFs can provide mind-boggling gains when timed correctly, they can also cause equally mind-boggling losses when bought at the wrong time. Therefore, investors considering UPRO should wait for a major market correction and use the ETF to supercharge returns in the recovery.

Risk of total wipeout

UPRO is a leveraged ETF that seeks to replicate the daily movements of the S&P 500 by a factor of three. This means that if the S&P 500 increases by 2% in a day, UPRO's price should increase by six per cent. Conversely, if the S&P 500 decreases by a certain percentage in a day, UPRO's price should decrease by three times that amount.

The problem with this is that UPRO can experience a total wipeout if the S&P 500 declines more than 33% in a single day. This is because UPRO's value is relative to the S&P 500's performance. So, if the S&P 500 loses more than 33% in a day, UPRO's value will be multiplied by a factor of three, resulting in a loss of 99%.

For example, if you invest $100 in UPRO and the S&P 500 loses 34% in a day, your investment will be worth just $1. This is because a 34% loss multiplied by three is a 102% loss, leaving your investment worth just a fraction of its original value.

This risk of total wipeout is one of the main reasons why investors are discouraged from holding UPRO and other leveraged ETFs over the long term. While these funds can provide short-term gains if the market moves in the right direction, they are highly vulnerable to significant losses in volatile markets.

The high expense ratios associated with leveraged ETFs further compound the risks. These funds often charge around 1% per year, which can add up to significant losses over time, even if the underlying index performs well.

In conclusion, the potential for total wipeout due to high volatility and the high expense ratios makes UPRO and other leveraged ETFs unsuitable for long-term investing. These funds are designed for short-term trading and should only be considered by experienced investors who understand the risks and are prepared to accept them.

Not suitable for long-term investing

Leveraged ETFs like UPRO are not suitable for long-term investing due to the risks associated with volatility and volatility decay. While they can amplify gains, they also amplify losses, and in volatile markets, this can lead to large losses.

For example, if the S&P 500 moves up 1% a 3x ETF will increase by 3%. So, if the S&P 500 declines by 3% the next day, a 3x ETF will decline by 9%. This back and forth movement in the market can result in a net loss even if the S&P 500 ends up. This is known as volatility decay.

The impact of volatility decay is more pronounced over longer periods, and the longer the holding period, the more the investor's return tends to deviate from the daily target. This is because leveraged ETFs are designed for short-term trading and aim to replicate the daily price movements of the index they track.

Additionally, 3x ETFs get their leverage by using derivatives, which introduce another layer of risk. These include "market risk", "counterparty risk", "liquidity risk", and "interconnection risk".

Furthermore, due to their design, 3x ETFs will eventually face complete collapse if the underlying index declines more than 33% on a single day.

Finally, 3x ETFs also have high expense ratios, which make them unattractive for long-term investors as these fees add up to significant losses over time.

In conclusion, while UPRO and other leveraged ETFs can be tempting due to their potential for amplified gains, they are not suitable for long-term investing due to the risks associated with volatility, volatility decay, derivatives, and high fees.

Requires deep understanding of the security

UPRO is a leveraged ETF that seeks to replicate the daily movements of the S&P 500 multiplied by a factor of three. This means that if the S&P 500 increased by 2% in a day, UPRO's price should increase by six per cent. Conversely, if the S&P 500 decreases by a certain percentage in a day, UPRO's price should decrease by three times that amount.

While UPRO has the potential to hugely magnify the returns of an investor's portfolio, the leverage it uses is a double-edged sword. UPRO is considered a risky but potentially high-reward security. Its performance is dependent on the upward movement of the S&P 500, and it is typically used as a short-term tool to speculate on the daily price movements of the S&P 500.

Due to a phenomenon known as volatility decay, conventional wisdom suggests that leveraged ETFs perform poorly over the long run. Volatility decay can cause UPRO to have price decreases when the S&P 500 is largely flat. For example, if the S&P drops by 20% one day and recovers by 25% the next, the S&P ends up where it began, but UPRO would have experienced a 60% drop in price, followed by a 75% recovery, ending the two days down 30%.

However, UPRO benefits from its leverage factors when the underlying index moves homogeneously upward. For example, if the S&P 500 goes up 10% on the first day and 10% on the second day, resulting in a net 21% increase, UPRO would go up 30% and 30% respectively, for a net 69% increase.

Ultimately, UPRO is not considered a safe investment, no matter the perceived margin of safety in the S&P 500. It is most suited to experienced investors with a deep understanding of the security and the risk tolerance to endure the volatility that high leverage brings.

Frequently asked questions