Leveraged ETFs Are Booming, But Are Advisors Buying?

The leveraged ETF market is awash with new products, targeting everything from crypto to AI and semiconductor manufacturing.

Advisors aren’t always impressed, however. Although leveraged ETF assets doubled to $220 billion from March 30 to June 3, advisors and broker-dealers face restrictions on recommending the products to their clients. Advisors have to understand their risks, make sure they align with clients’ best interests and not buy too many of them, per FINRA rules. That’s because leveraged funds can often lose significant amounts of money in flat markets since they reset daily. And sometimes those advertised yields don’t match client expectations, experts said. Advisors will want to educate themselves on new products as the ETF industry continues to innovate.

“I spend a lot of time pulling clients out of products that looked brilliant going in and quietly cost them later, and leveraged ETFs sit near the top of that list,” said Jeff Judge, a founding partner and CFP at Chesapeake Financial Planners. “For most people, the risk swamps the reward.”

Draggin’ Volatility

Although institutional investors are one of the forces behind the recent surge in demand for leveraged ETFs, there has also been strong interest from individual investors. The top financial regulator in South Korea, which had its own leverage-induced volatility scare earlier this month, said last week that over 90% of the products are held by retail investors.

“From an advisor’s perspective, leveraged ETFs are tools for trading, not vehicles for investing,” said Scott Bishop, partner and managing director at Presidio Wealth Partners. “The key risk is that many investors misunderstand what they actually own.” Some assume that a 2x leveraged ETF will net double the yield, but most leveraged funds are designed to deliver multiples of an index’s daily return, not its long-term return, he added. “Over time, daily resets, compounding, volatility drag, tracking error, and — in futures-based products — dynamics like contango and backwardation can cause returns to diverge meaningfully from what an investor expected.”

The dangers are evident in some recent leveraged product downswings:

• The Direxion Daily MSCI South Korea Bull 3X ETF (KORU) fell 42% in a single day earlier this month.
• The Defiance Daily Target 2X Long MSTR ETF (MSTX) and the T-REX 2X Long MSTR Daily Target ETF (MSTU), which track the bitcoin treasury company Strategy, are both down about 95% year to date.

What’s the Use (Case)? That’s not to say leveraged products aren’t useful. For traders with a short-term time horizon, or for sophisticated investors who can monitor their holdings closely and exit when necessary, they may fit the bill. But Bishop said most buy-and-hold investors, and his own clients, don’t fall into that category. Judge agreed: “If they insist, the only responsible way to hold it is a small satellite position with a defined exit [and] money they can lose entirely, never income they rely on, and never the core.”

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