Are leveraged ETFs driving the stock rally?

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Stock markets were broadly higher on Monday, reversing course from Friday’s swoon when it became clear President Trump was responding well to treatment for his COVID-19 infection. The gains for the main market benchmarks have been substantial, with the Dow Jones Industrial Average (DJINDICES: ^ DJI) and S&P 500 (SNPINDEX: ^ GSPC) pick up almost 2% on the day.

Today’s stock exchange

Index

Percent change

Point change

Dow

+1.68%

+466

S&P 500

+1.80%

+60

Nasdaq Composite

+ 2.32%

+257

Data source: Yahoo! Finance.

Many investors are looking for the fastest way to get rich. For them, using leveraged ETFs can be an easy way to try and multiply their earnings when they make correct calls. However, those who do not fully understand leveraged ETFs do not always appreciate the danger they represent. Below, we’ll take a look at how leveraged ETFs have become more popular and what risks you should be aware of.

Image source: Getty Images.

Can you really triple your returns?

Leverage ETF are designed to produce daily returns which are multiples of the returns of certain market benchmarks. They usually do this through the use of derivatives.

The keyword above is “daily”. When you look at most leveraged ETFs, they do a great job of doing exactly what they claim to offer: tracking the performance of an index over a day.

Different levels of leverage are available from different ETFs. Some are designed to double the return of an index, while others are more aggressive and offer triple the returns. You can also usually get reverse leveraged ETFs, where the stock price rises when the market goes down and vice versa.

Leverage ETFs have become increasingly popular in recent times. For example, the ProShares Ultra Pro QQQ (NASDAQ: TQQQ), which offers three times the daily return of the Nasdaq 100 index, traded almost as many stocks today as the regular ETF Invesco Trust QQQ (NASDAQ: QQQ). The reverse ETF 3x ProShares Ultrapro Court QQQ (NASDAQ: SQQQ) negotiated Following shares, although its share price is much lower than that of QQQ Trust.

When leveraged ETFs fail

The focus on daily returns makes leveraged ETFs less effective for investors seeking increased exposure to the stock market over the long term. The investments these leveraged ETFs use are not designed for longer time frames, so their effectiveness is mixed at best.

For example, when you look at 2020 to date, you will see that the Invesco QQQ trust is up about 32%. Some might expect a leveraged triple exposure ETF like ProShares UltraPro QQQ to triple that amount. Instead, it’s up 54% – an impressive outperformance but only 1.7 times the return of QQQ. Meanwhile, the UltraPro Short QQQ is down almost 80% – again, not quite double the reverse but still a painful loss.

Sometimes the result can make everyone a loser. Over the past month, with wild swings in the market, the QQQ is down 1%. The UltraPro Long 3x Leveraged ETF is down 5% which is understandable and not too far off from the theoretically correct value. However, the UltraPro Short QQQ ETF is too down, down more than 2%.

That the investor beware

It is true that leveraged ETFs can greatly improve your returns when the stock Exchange moves in one direction for an extended period. From March to August, for example, the UltraPro QQQ has effectively better than tripling the returns of the Nasdaq 100.

Over the long term, however, leveraged ETFs have almost always fallen short of target. This makes them dangerous tools for those who are unaware of their shortcomings. If more and more people are using leveraged ETFs without fully understanding them, it could bode well for the health of the current bull market.

This article represents the opinion of the author, who may disagree with the “official” recommendation position of a premium Motley Fool consulting service. We are heterogeneous! Challenging an investment thesis – even one of our own – helps us all to think critically about investing and make decisions that help us become smarter, happier, and richer.

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