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Why I’d steer clear of leveraged ETFs

Leveraged exchange traded funds (ETFs) or exchange traded products (ETPs) may sound like the preserve of traders, but their presence among the private investor community is ticking up. Strikingly, the number of people who own a leveraged ETF via AJ Bell has increased by 70 per cent since February, with 1,700 customers now owning at least one out of the 163 available on this platform.

Hargreaves Lansdown, meanwhile, has closer to 10,000 customers in leveraged ETFs with WisdomTree FTSE 100 3x Daily Leveraged (3UKL) the most popular, a ranking the product also has on Hargreaves’ rival, interactive investor. 

It’s easy to see why people are drawn to leveraged ETFs. As markets have broadly been strong this year, why not jack up returns by building in leverage? Well perhaps because these products might not behave in the way you would expect. 

If you are tempted to buy a leveraged ETF or ETP, make sure you understand exactly how it works and why they are typically only held by day traders. Most leveraged ETF and ETPs will aim for a 2:1 or 3:1 ratio, by using borrowed funds to buy options and futures to amplify their returns. 

Importantly, for most products, the leverage is calculated on a daily basis. So, for example, imagine you had a 3x leveraged long ETF and the market went up 10 per cent one day, down 5 per cent the next and down again 5 per cent on the third day. Transaction fees excluded, if you invested £100, you’d have £130 by the end of the first day, £110.50 after day two and £93.92 after day three – leaving you over £6 out of pocket. 

The unleveraged equivalent would leave you with £110 after day one, £104.50 after day two and £99.275 after day three. So the losses on the leveraged version would be considerably more than three times higher than those of its unlevered counterpart. And, in reality, your returns would be even worse with a leveraged product because the fees are higher. Premiums need to be paid to buy the options contracts and the cost of borrowing needs to be factored in, which is why most leveraged ETFs have expense ratios higher than 1 per cent. 

WisdomTree FTSE 100 3x Daily Leveraged has portfolio transaction costs of 1.4 per cent which include the costs of buying and selling investments for the product. And it has a 0.75 per cent management fee on top of that. 

The chart below shows how the WisdomTree ETP in question has performed compared with its peers over the past five years. While the returns are slightly higher, they are nowhere near three times higher. 

The same returns calculated over a three-year period show a 2.4 per cent rise for the benchmark and a 34 per cent fall for the product. The longer the time frame, the more uncoupled from the underlying index the returns become. 

Traders may find leveraged ETFs helpful for hedging parts of their portfolio on a short-term basis, which can be pretty effective if you know what you are doing. But for most investors, it looks more like gambling.