Leveraged ETFs have been very hot in recent years. As the name implies, leveraged ETFs actually mean adding leverage on the basis of ordinary ETFs, which can be 2x, or 3x.

There are hundreds of leveraged ETFs on the market that track a variety of assets, indices and sectors. Leveraged ETFs tracking the S&P 500 and NASDAQ 100 are the most popular.

However, investors have found a strange phenomenon when holding these leveraged ETFs for a period of time, even though the large index is the same, the price of the ETF fell and therefore suffered losses.

What the hell is going on?

In this article, we will explain in detail what a leveraged ETF is, its advantages and risks.

What is an ETF

Before getting to the point, let's review the basics of ETFs.

An ETF, an exchange-traded fund, is an investment fund that can be traded on a stock exchange like a stock.

An obvious feature of an ETF is that its price movements are almost replicating the movement of an index.

For example, SPY and QQQ are the two most popular ETFs that track the movement of the S&P 500 and NASDAQ 100.

If the S&P 500 is up 1% in a month, SPY is generally expected to rise by 1%, and vice versa. (Trend may be slightly deviated due to ETF-related fees and expenses)

This is because SPY's position includes all stocks of the S&P 500 index, including Apple, Microsoft, Amazon and many more.

Here is a share of knowledge points worth paying attention to investors:

Since the S&P 500 is a capitalise-weighted index, the greater the impact of companies with larger market capitalization on the index, the smaller the impact of companies with smaller market capitalization on the index. Therefore, large market stocks tend to have a greater impact on SPY.

The figure below is the weight of SPY component stocks, which can be seen with the highest weight of Apple, followed by Microsoft. Thus, Apple share price fluctuations, the biggest impact on SPY.

So now you will see why you often see things like “Apple fell, dragged down the market” in the financial media.

What is a Leveraged ETF

Now that we know what an ETF is, leveraged ETFs have a good understanding.

Ordinary ETFs track the movement of the index, while leveraged ETFs magnify the index exponentiallyIntra-day Trend.

In general, these funds end up tracking the index exponentially by holding financial derivatives such as futures and swap contracts.

The ProShares NASDAQ Triple Multiplier ETF (TQQQ) is a good example of tracking the NASDAQ 100 Index, but with the purchase of additional index futures and other derivatives, it ends up to 3x the tracking effect.

In other words, if the NASDAQ 100 index rose 1% in the day, TQQQ will probably rise 3% that day. Conversely, if the index falls 1%, TQQQ will also fall 3%.

The following chart shows the NASDAQ 100 index (NDX) and TQQQ on February 14, 2023.

It can be seen that the NASDAQ 100 index closed at 12590.89 points on the day, up 0.71%. TQQQ closed at $25.49, up 2.16%, rising almost three times the NASDAQ 100 index.

However, while leveraged ETFs can amplify returns in one day, long-term holdings come with other risks.

What happens with prolonged holding?

One of the biggest risks of holding a leveraged ETF for a long time is shock loss.

Since leveraged ETFs only track the index's gains and falls for a day, the compounding effect may cause additional losses to investors during market volatility.

Returning to our previous examples of the NASDAQ 100 Index (NDX) and TQQQ, the chart below shows their movements during the period of September 9, 2022 - February 14, 2023.

• The NASDAQ 100 index closed at 12588.29 on September 9, 2022, and then experienced a wave of decline, eventually returning to the previous point on February 14, 2023.The return of the index is 0% during this time period.

• TQQQ closed at $29.68 on September 9, 2022, also experienced a wave of decline, eventually closing at $25.49 on February 14, 2023.The return of TQQQ during this time is -14%.

This can be seen that after five months of holding TQQQ, he will still lose 14% even if the NASDAQ 100 index returns to the previous point after falling.

In addition, the higher management fees and handling fees of leveraged ETFs will cause losses.

Understanding Vibration Impairment

To better understand the principle of vibration loss, take a simple mathematical example.

Suppose the Nasdaq 100 index and TQQQ start position/price are both 1000.

If the index change for 4 consecutive days is: down 10%, 10%, down 10%, 30%, after 4 days, the index position is =1000* (0.9) *1.1* (0.9) *0.9) *1.3 = 1158.3, the return of the four-day index is 15.83%.

The corresponding analogous triple ETF (TQQQ) is: down 30%, 30%, down 30%, 90%, after 4 days, the price of TQQQ is = 1000* (0.7) *1.3* (0.7) *1.9 = 1210.3, the return of TQQQ for the four days is 21.03%.

Although the overall TQQQ also increased, due to seismic losses, its margin of 21.03% was less than three times the previous forecast, or 47.49% (15.83% *3).

When to use a leveraged ETF?

In summary, leveraged ETFs can provide attractive returns in the short term. But long-term holding carries greater risks.

So people who invest in leveraged ETFs, should pay attention to:

• Leveraged ETFs may not be suitable for long-term holding, as shock losses eat up some of the gains while also potentially magnifying losses.

• Leveraged ETFs are more suitable for intraday traders looking for high returns. But traders need to have a high tolerance for risk, as leveraged ETFs have a range of two or three times that of the benchmark index (or vice versa).

• In addition, traders who stake these ETFs should develop appropriate risk management strategies and be prepared to close their positions at the end of each trading day.