Are Leveraged ETFs Really Going To 'Blow Up'?

This week, Blackrock (BLK) CEO Laurence Fink was quoted as saying that leveraged ETFs are a structural problem and have the potential to “blow up” the industry. 

Blackrock is the parent company of ETF powerhouse iShares, which does not currently operate any leveraged ETFs.  In fact, Fink went so far as to say that Blackrock “would never do a leveraged ETF”. 

While many industry experts agree that leveraged ETFs are not for the faint of heart, not many have been quoted as saying that they will cause catastrophic effects.  They are generally regarded as aggressive investment vehicles for disciplined investors with short-term time horizons. 

The use of leverage within an ETF can compound both positive and negative returns very quickly.  This is because the daily returns of the underlying index are magnified by two or three times, depending on the type of ETF.

For example, the ProShares Ultra S&P 500 ETF (SSO) seeks investment results that correspond to two times the daily performance of the S&P 500 Index.   

Simply put, if the S&P 500 Index increases 1% in a single day, SSO will jump 2%.  There are also a wide variety of inverse leveraged ETFs from ProShares and DirexionShares as well. 

With total assets of over $3 billion in SSO, there is clearly demand for these fast-moving vehicles.   However, there are also issues that can crop up when you hold these vehicles for too long. 

One common issue with leverage is how its compounding effect erodes the tracking efficiency of the underlying index over time. Leveraged ETFs are only designed to track the daily price movement of a specified index. Thus, investors should not expect that a 10% move in an index for a 2x leveraged ETF over a three-month time frame is going to correlate perfectly to a 20% return.

In addition, many leveraged ETFs use swaps, futures, and other esoteric means to achieve their stated objectives.  These types of non-traditional investments are much different than a conventional basket of underlying stocks or bonds. 

Each investor should consider these risks before implementing a leveraged ETF in their portfolio.  However, the majority of these funds have had a successful history of accomplishing their stated goals and rebalancing their underlying holdings on a daily basis to realize liquidity.