If you have access to more sophisticated financial products, you may have heard of leveraged ETFs. These are short-term tools, but our investor this week – whom we’ll simply call G – made the drastic mistake of holding on to a leveraged (US-based) ETF for an entire month. The reason? An oversimplified understanding of the product, and not really reading the prospectus. Let’s learn from his mistake:
If ETF = Good, then Leveraged ETF = Better, correct?
That’s what G had assumed. A leveraged ETF, such as a double or triple ETF, moves by two or three times the underlying index.
So if an ETF is pegged to the S&P 500, and the index goes up 1%, the ETF will also go up by 1%. If it goes down by 1%, the ETF does the same (at least in theory, ignoring factors like tracking errors).
But if it’s a triple ETF, the movement is tripled. When the S&P 500 goes up 1%, the triple ETF goes up 3%, and vice versa.
These sorts of products, almost always US-based, might appear on some brokerage platforms in Singapore. But if you care to read the prospectus or various descriptions, they almost always come with a warning that you’re not supposed to hold on to them for long periods; these are typically held for hours to a few days.
It’s something G wishes he’d paid attention to, or consulted someone about first. He explains that:
“My understanding is just surface level, and my thinking was that if ETFs are good and always grow over time, then why not double or triple it? If an ETF can have a steady return of 7%, then a triple ETF maybe can do 21%.”
It was this thinking that led G to buy a triple ETF, which he held onto for an abnormally long period of several months, before he became aware of the damage. By then, G was down by what he says is “close to five digits.” Not what one might call life-changing damage, but a painful way to learn the dangers of oversimplification, and volatility drag.
What makes a leveraged ETF so dangerous?
Leveraged ETFs stray very quickly from the underlying index, due to the compounding effects of losses when the index dips. Here’s a hypothetical two-day example:
| Day | Underlying index | Triple ETF | % change |
| 0 | $100 | $100 | N/A |
| 1 | $110 | $130 | 30% |
| 2 | $99 | $91 | 30% |
Note that when the index goes down by 30%, the ETF loses 30% of $130. So whilst the underlying index is almost flat after two days (just a dollar off from starting value), the triple ETF is much farther off by $9.
This is just over two days, and the longer it goes on, the more the volatility will amplify losses and cause the leveraged ETF to deviate.
In the case of G, who had held on for a few months, he lost “about a quarter” of what he’d put in. He ascribes some of the blame to the brokerage platform, as notifications and alerts allegedly failed to work, but admits most of this was on him.
Knowing the subtle but important differences
G says he doesn’t usually invest in things outside his comfort zone; but he’d made the mistake of ignoring nuances. When it comes to financial products, G says that:
“There are many things that sound very similar, I guess because many products are variants of existing ones, and the overall concepts they share are also the same. So now I am more aware of how different ETFs can be from each other, how index funds are so varied, and so on.”
G also says there was some allure in the novelty of it; there was “some feel-good factor because I felt I was doing something smart and different,” which isn’t as silly as it sounds. Quite a few investors plunge money in NFTs, long-shot companies, or stamp funds for the simple reason that they’re more exciting than, say, owning a barrel of oil or a bond.
And while that’s not always wrong (some of the best investors keep 5% of their portfolio in fancy alternatives), it’s best to ask an expert, and be a bit paranoid about how much you really understand. Above all, beware of products that sound very similar to conventional ones, such as ETFs, but work quite differently.
If you’ve been burned by a financial product, help others avoid the same situation. Reach out to us on Single Digit Millionaire, and let us know.
