Leveraged ETFs, unlike most ETFs you can buy at your friendly neighborhood broker, are generally (there are some exceptions) vehicles for short term market timing, only maintaining a fixed leverage through a single trading period, and resetting leverage daily. Due to the constant need to rebalance, there is a systemic risk of leveraged ETFs.
This phenomenon means that a 2x or a 3x levered fund exhibits a behavior known as the “constant leverage trap“, an issue we’ve discussed previously on this site. In short: you won’t match the exact multiple of gains of losses you thought you bet on if you hold more than a day.
The Systemic Risk of Leveraged ETFs
Of course, the concern here runs deeper than folks incorrectly using leveraged ETFs. Because these funds are chartered to make the exact same trades every day – using derivatives to maintain a perfect 2x or 3x (or whatever) ratio for the next trading session – it means you’ve got a loaded, and yes, predictable trade which we all assume will continue to work perfectly well in the future.
Compare that to Mortgage Backed Securities: there was a market, daily, until there wasn’t… and, as it turned out, someone (one ‘someone’: AIG) was left holding the bag.
So, consider the nightmare scenario: hundreds of funds scrambling to lever their funds for the next trading day, only to run into exorbitantly expensive options for producing the leverage they need. Now, a typical investor might just say “not today”… but what will happen when you’ve got a bunch of well capitalized funds fishing in an unstocked pond? (And, no – a typical investor shouldn’t hold leveraged ETFs in their portfolio.)
The number of leveraged ETFs outstanding is nowhere close to the market in mortgage backed securities, sure, but still a sizable amount of the ETF market. Leverage effectively means controlling additional assets using a smaller base of assets – so any problems would be multiplied a bit from that base.
But again – 2x or even 3x leverage, versus a zero down payment no document loan isn’t really a battle, is it?
I’m Still Sleeping Well
Sure, a blowup in the leveraged ETF industry would cause some significant volatility, and take out a few funds. Perhaps I’m discounting some major hedge funds employing leveraged ETFs as hedges going under, or some other unseen factor – but I’m much more concerned about the trillion dollar levels of student loan debt than I am people who are betting 2:1 on equities. But, hey, I’m open to being convinced – how bad do you think a leveraged ETF blowup would be? Where could the ‘contagion’ (there’s a 2008 word, if I’ve ever seen one) could spread?
And, for the typical investor, stick to the non-levered type of funds. Even in my Stock Picking Contest 2014! portfolio, the leveraged funds I chose were either:
- Leveraged due to the nature of the security (VIX products)
- “Varied” leverage (the Barclays fund, which doesn’t re-leverage daily)
But for most folks: you want leverage? Buy a house. There is definitely potential for systemic risk of leveraged ETFs… you might as well keep your portfolio away from it.