Do Leveraged and Inverse ETFs Converge to Zero? (2024)

FAQs

Do Leveraged and Inverse ETFs Converge to Zero? ›

Over the long-term, inverse ETFs with high levels of leverage, i.e., the funds that deliver three times the opposite returns, tend to converge to zero (Carver 2009 ).

Leveraged ETF prices tend to decay over time, and triple leverage will tend to decay at a faster rate than 2x leverage. As a result, they can tend toward zero.

This shows that the potential for both profit and loss can be magnified with leveraged inverse ETFs. It is also important to note that leverage also means it is possible that a leveraged inverse ETF can go to zero or near zero with a large enough daily move in the price of the underlying asset or index.

For most standard, unleveraged ETFs that track an index, the maximum you can theoretically lose is the amount you invested, driving your investment value to zero. However, it's rare for broad-market ETFs to go to zero unless the entire market or sector it tracks collapses entirely.

"They all go to 0 over time." "If you hold them for more than a few days, you will lose money." The 3x Long Nasdaq 100 ETF (TQQQ) was launched in February 2010, over 8 years ago. Since its inception, it has advanced 4,357%, versus a gain of 378% for the unleveraged Nasdaq 100 ETF (QQQ).

In other words, you could potentially be liable for more than you invested because you bought the position on leverage. But can a leveraged ETF go negative? No. If you own a leveraged ETF you can't lose more than your initial investment amount.

Bottom Line on Leveraged ETFs

Leveraged ETFs decay due to the compounding effect of daily returns, volatility of the market and the cost of leverage. The volatility drag of leveraged ETFs means that losses in the ETF can be magnified over time and they are not suitable for long-term investments.

Leveraged ETFs amplify daily returns and can help traders generate outsized returns and hedge against potential losses. A leveraged ETF's amplified daily returns can trigger steep losses in short periods of time, and a leveraged ETF can lose most or all of its value.

Investors who wish to hold inverse ETFs for periods exceeding one day must actively manage and rebalance their positions to mitigate compounding risk. The effect of compounding returns becomes more conspicuous during periods of high market turbulence.

TQQQ is one of the largest leveraged ETFs that also tracks the Nasdaq-100. QQQ is perhaps best suited as a long-term investment for those who want broad exposure to the Nasdaq-100 Index. TQQQ is built for short-holding periods and is best suited for day traders.

Are inverse ETFs leveraged? ›

Leveraged inverse ETFs (also known as “ultra short” funds) seek to achieve a return that is a multiple of the inverse of the underlying index's daily performance.

REBALANCING HELPS NARROW THE GAP

The performance of leveraged and inverse mutual funds and ETFs is affected by compounding—which means that, over time, their performance may be greater or less than the fund's stated (daily) objective times the index return.

BMO has launched the first quadruple leveraged ETN fund that tracks the S&P 500. The fund will trade under the ticker symbol "XXXX" and seeks to generate four time the S&P 500's return on a daily basis. The launch come as bullishness rise among investors and Wall Street predicts more gains to come in 2024.

Theoretically, any investment, including QQQ, can experience a decline in value and potentially become worthless. However, it is important to note that QQQ represents a basket of established companies listed on the Nasdaq Stock Market, which makes the likelihood of it going to zero highly improbable.

How Long Should You Hold a Leveraged ETF? Because of the volatility associated with leveraged ETFs, it is inadvisable to hold them after market close. Otherwise, you may see the value of your investment gap down 5% to 10% when the market reopens.

Pay attention to the impact of volatility decay！ When investing in leveraged ETFs like TQQQ, investors need to be aware of the impact of volatility decay. For example, in a volatile market, if the Nasdaq 100 Index drops by 10% in a day, TQQQ will drop by approximately 30%.

QQQ has consistently outperformed TQQQ in dividend yield by an average of 0.84% from 2014 to 2022. In fact, since 2014, TQQQ has generated nearly no dividends outside of 2023, when it outperformed QQQ. Overall, QQQ has a lower expense ratio, less risk, and a higher dividend yield compared to TQQQ.

Over even longer time horizons, every percentile (except the 100th) of the ETF's value will eventually converge to zero.

Historically, SQQQ decays around 7-8% per month, though this would likely be around 4-5% per month during a flat market such as that experienced so far this year.

If the index rose 2%, a 2x leveraged ETP would aim for a 4% return (if it fell, the loss would also be magnified by 2x). Inverse ETPs, on the other hand, attempt to deliver multiples in the opposite direction, so if the index rose 2%, a 2x inverse ETP would generate a negative 4% return.

Is it bad to buy leveraged ETFs for long-term? ›

Nearly all leveraged ETFs come with a prominent warning in their prospectus: they are not designed for long-term holding. The combination of leverage, market volatility, and an unfavorable sequence of returns can lead to disastrous outcomes.

Most leveraged and inverse ETFs reset each day, which means they are designed to achieve their stated objective on a daily basis. With the effects of compounding, over longer timeframes the results can differ significantly from their objective.

Volatility of Leveraged ETF

Another leveraged ETF risk is the leveraged ETF volatility. Maintaining a constant leverage ratio that is probably two or three times the usual amount is typically hard. The price of the underlying index fluctuates, changing the leveraged funds' assets value, depicting high volatility.

Maintaining a constant leverage ratio allows the fund to immediately reinvest trading gains. This constant adjustment, called rebalancing, is how the fund is able to provide double the exposure to the index at any point in time, even if the index has recently gained 50% or lost 50%.

Because leveraged single-stock ETFs in particular amplify the effect of price movements of the underlying individual stocks, investors holding these funds will experience even greater volatility and risk than investors who hold the underlying stock itself.

The daily rebalancing of leveraged and inverse ETFs creates a situation that for periods longer than a day or two the return of a leveraged or inverse ETF will deviate from the margin account benchmark.

While you are not required to repay the leverage itself, you must maintain a sufficient amount of capital in your trading account to cover potential losses. If your account balance falls below the required margin level due to trading losses, you may receive a margin call from your broker.