Leveraged ETFs Have a Place in a Well-Balanced Portfolio

Venture over to the “Topics” tab on etf.com and you will find your way to a helpful page on funds that employ leverage to jack up the returns of their underlying assets.  

Financial advisors and investors who learn more about these intentionally volatile leveraged ETFs might find a great asset for a well-balanced investment portfolio. And with leveraged ETFs now offering exposure to dozens of underlying asset classes and even single stocks, there’s a case to be made that they are not just for traders anymore.  

To be sure, advisors whose firm compliance is overseen by someone other than themselves (i.e. they outsource it or work for a larger firm) may not change their minds about the viability of leveraged ETFs. But they might at least argue sensibly for certain cases where they are more beneficial to investors than many ETFs that are routinely acceptable. 

The Case for Leveraged ETFs 

As a quick but relevant aside, I was an advisor for 27 years, but never used or even considered using an ETF that had more than a modest amount of leverage. I am a big fan of ETFs that perform opposite certain market segments because to only play offense in investing means that one is trusting the stock and bond markets to rise long-term. For more than half of this century, the SPDR S&P 500 ETF Trust (SPY) only broke even.  

At the start of 2000, SPY traded at $147 a share. At the beginning of 2013, SPY had gone all the way to…$146 a share. In between, SPY never traded higher than $156.41, and only exceeded the 2000 starting price briefly during that entire time. Leveraged ETFs that perform inversely to a major market index can potentially reduce the downside risk here. And, while they become less effective when the market increases for extended periods, advisors can adjust to that risk by keeping position sizes low (since the leverage will compensate for it) and setting pre-determined loss tolerance levels, as they would for any ETF or stock in a portfolio. 

For an example, take the first nine weeks of 2009, after 2008 had already done significant damage to the S&P 500, with a 37% decline. The $300 million Direxion Daily Small Cap Bear 3X ETF (TZA) was new then, and when SPY fell 25% during those first nine weeks of 2009, TZA climbed by 137%. As the market recovered sharply after that, TZA’s value fell by well over half. But there was ample time for an advisor to adjust.  

Minimizing Risk 

Having even, say 5% allocated to vehicles that can potentially be a bear market deterrent, makes a huge difference in overall returns. Again, this is just one historical example, designed to introduce the math that combines leveraged ETFs, small position size in a portfolio, and the panicked clients amid a market meltdown. 

The Nasdaq 100 index has had drawdowns of 78%, 51% and 34% this century. That is thought of by many as a “long-term investment.” Leveraged ETFs are not long-term investments, but they are tactical tools that advisors can use to supplement their core holdings.  

The challenge, regardless of a fund’s goals, or whether it tilts bullish or bearish, is to place them properly in a well-rounded portfolio and to minimize risk.