Blowed up real good

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  By Guest Blogger Doug Rowat

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After educating readers on the many dangers of leveraged ETFs, along comes a product that’s even riskier: single-stock leveraged ETFs.

Leveraged ETFs are much like grenades—they mostly work as intended, but for inexperienced users, they’re just as likely to blow up in your hand. Now we have the advent of single-stock leveraged ETFs, products that have been around in North America since 2022, but have gained more prominence in just the past year, primarily due to the dramatic rise of the Magnificent Seven tech stocks.

Before I explain how these new ETFs can get you blowed up real good; as a refresher, how do leveraged ETFs work in general and why are they problematic?

Leveraged ETFs typically use mechanisms such as swaps, futures contracts and derivatives to provide investors with some multiple (usually 2x) of the daily returns (up or down, and sometimes the inverse of either) of an underlying benchmark. The key term, however, is DAILY. These are products that don’t necessarily amplify returns over the long haul, rather just the returns over a SINGLE trading day.

As a result of daily price resets, ‘volatility drag’ is a constant feature of leveraged ETFs. A see-saw pattern of daily market returns over a prolonged period can significantly diminish returns. The results can quickly become devastating—and unexpected given the typical product branding: “ultra”, “enhanced”, “2x Bull”, “2x Bear”, etc.

This is where the confusion sets in: investors mistakenly assume that the labelling and multipliers mean amplified returns over the long term, but the returns on leveraged ETFs don’t compound. Daily price resets combined with periods of high volatility often finish off investors’ hopes of realizing leverage on the long-term gains (or losses) of an underlying benchmark. To illustrate:

• If you invested $1,000 in an unleveraged ETF tracking the S&P 500 and the S&P 500 went from 5,500 to 5,800 on the first trading day then back to 5,500 on the second, you would be flat over the two days.
• However, a 2x leveraged ETF investor would be up 10.9% on the first trading day, or up to $1,109, but on the second day would be down 10.3%, or down to $995—a loss.

Do this enough times, over enough trading days, and your returns steadily erode.

Now we have the introduction of single-stock leveraged ETFs, which are even more dangerous because a single security will almost always be more volatile than a broad-based index. Single-stock leveraged ETFs tap into an investors’ gambling mindset, which is problematic in and of itself, but for investors who don’t pay extremely careful attention (literally, daily attention) to these ETFs, the consequences can be severe.

Let’s use Tesla as an example. The Nasdaq Composite is up roughly 50% over the past two years, so many investors might have anticipated that Tesla, as the sixth heaviest-weighted Nasdaq component, would be up as well. However, Tesla’s down about 6%. Naturally, if you’d decided to employ a single-stock leveraged ETF of perhaps the 2x-bull variety to benefit from a positive Tesla outlook, your returns have almost certainly been sharply negative over the past two years.

But here’s where things get interesting. If you’d correctly (and miraculously, I might add) predicted Tesla’s decline and then prudently invested in a ‘bear’, or inverse, single-stock leveraged ETF, which are designed to benefit if the underlying Tesla shares decline, volatility drag still would have torpedoed your investment strategy. Simply to illustrate, let’s say you invested in the Tradr 2x Short TSLA Daily ETF (TSLQ) and held the ETF for the same two-year period, the results would have been devastating. TSLQ is a short-term tactical investment tool only. Like all single-stock leveraged ETFs, TSLQ is technically designed only to be held for a day, certainly not for two years. Thanks to volatility drag, the performance of TSLQ has been significantly WORSE than the underlying Tesla stock:

Example of single-stock leveraged ETF volatility drag

Source: Google Finance, Turner Investments. * weekly pricing

Individual securities, especially the risky variety that ETF providers are currently focusing on, are almost always more volatile than broader indices. In other words, the effects of volatility drag will be even more pronounced with individual stocks. To be fair, single-stock leveraged ETFs have generally done well recently, but it’s critical to remember that as your holding period increases, and particularly if volatility rises, so does your downside risk.

The single-stock leveraged ETF darlings at the moment are, naturally, those pegged to Nvidia, which has, by far, performed the best of the Magnificent Seven stocks over the past year. But, surprisingly, Nvidia’s volatility profile has been relatively calm, certainly much calmer than Tesla’s:

Nvidia vs Tesla: which shares have exhibited lower volatility?

Source: Turner Investments. Volatility measures the standard deviation of daily price returns.

As a simple illustration of the volatility difference, over the past five years, Nvidia has had a one-day price move (either up or down) of more than 10% only 12 times. Tesla’s price, in contrast, has had a one-day move of 10% or more a whopping 43 times! Thus, the significant performance erosion from volatility drag for those Tesla leveraged ETFs. As a further point of comparison, the Nasdaq Composite, of which both Tesla and Nvidia are members, has had ZERO daily moves of 10% or more over the past five years. If Nvidia’s volatility ever starts to rival Telsa’s, and eventually uncertainty strikes every company’s share price, investors owning the Nvidia leveraged ETFs may be in for an unpleasant surprise.

Predicting the direction of an individual stock is difficult enough, but if you utilize leveraged ETFs, you also have to correctly predict the stock’s future volatility. It’s an impossible task, and the longer you hold these ETFs the more your risk increases.

Grenades can only be held for so long. SCTV knew best how these things usually turn out:

Doug Rowat, FCSI® is Portfolio Manager with Turner Investments and Senior Investment Advisor, Private Client Group, Raymond James Ltd.