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How Every Leveraged ETF Can Cost Investors Money

Motley Fool - Fri Nov 4, 2022

Investors in the Nasdaq have seen huge ups and downs in the past several years. The beginning of the COVID-19 pandemic caused a near-panic in the stock market, but many of the tech stocks in the Nasdaq performed well once it became clear that their services would become essential to maintain business activity at reasonable levels. Yet once the Federal Reserve started to signal that it would push interest rates higher, investors got skittish about high-growth stocks with no current profits, and that sent the Nasdaq into a bear market.

When all is said and done, though, the Nasdaq-100 index has posted a reasonable gain of more than 23% since the beginning of 2020. However, those who tried to capture greater exposure to the Nasdaq through leveraged ETFs didn't fare so well. Regardless of whether you were bullish or bearish about the Nasdaq's future prospects, those who used leveraged Nasdaq ETFs came out on the losing side -- highlighting a key problem with these specialized investment vehicles.

Riding the wave

For much of the 2010s, the Nasdaq moved nearly straight up. That helped produce amazing returns for investors in standard ETFs like the Invesco QQQ (NASDAQ: QQQ), an index fund that simply tracks the normal movements in the Nasdaq-100 index.

Yet some people wanted to get even bigger returns in the bullish market. For them, ProShares UltraPro QQQ (NASDAQ: TQQQ) offered daily returns equal to three times the move in the underlying Nasdaq-100. Meanwhile, those who thought that the Nasdaq was overheating could invest in a similar ETF that took the opposing view. The ProShares UltraPro Short QQQ (NASDAQ: SQQQ) offered daily returns equal to three times the inverse of the underlying index. So if the Nasdaq-100 moved up 1% on a given day, the bullish leveraged ETF was designed to produce a 3% gain, while the bearish one would lose 3%.

As you might expect, during the long bull market, the bullish leveraged strategy worked well, while the bearish strategy did horribly. From February 2010 to December 2019, the short-leveraged ETF lost a stunning 99.9% of its value, but the bullish ETF rose nearly 50-fold.

Heads you lose, tails you lose too

All of that makes a degree of sense, but these leveraged ETFs weren't really designed to be used for long-term investing. The fact that the ETFs have a methodology that concentrates on daily returns makes them dangerous during volatile markets in which stocks aren't making much headway in one direction or the other.

As an example, take the past three years. As mentioned above, the Invesco QQQ ETF generated returns of about 23% over that timeframe. One might reasonably expect, therefore, to see the bullish leveraged ETF do better than that while the bearish ETF would post sizable losses.

As it turns out, though, both leveraged ETFs did poorly. The bullish ETF is actually down 20% since the beginning of 2020, as the damage caused during the bearish portions of the period outweighed the upward movements during the more bullish times. As expected, the bearish leveraged ETF got crushed, and even though it has rebounded sharply during the 2022 bear market, its share price remains 89% lower than where it was less than three years ago.

Leveraged ETFs aren't good long-term investments

When two opposing ETFs can both cause losses, it means there's something fundamentally flawed with the way they're set up. Although using leveraged ETFs can make sense for short-term trades betting on a move expected to happen within a few days, holding them for years has demonstrated itself to be a losing bet in the long run.

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Dan Caplinger has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.

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