A leveraged exchange traded fund attempts to use leverage in one form or another to achieve a stated multiple daily performance of a particular index or sector. For example, the Nasdaq-100 tracking stock (NDAQ symbol: QQQQ) is an ETF that tracks the performance of the Nasdaq-100 index. A leveraged ETF that seeks to double the daily performance of the Nasdaq-100 index is the ProShares Ultra QQQ exchange traded fund (NYSE symbol: QLD).
While the concept of a leveraged ETF sounds good in theory, the reality is that over periods longer than a day the performance will not live up to its supposed promise. This is due to a concept known as the constant leverage trap.
What is the Constant Leverage Trap?
Because the ETFs use leverage in the form of derivatives or debt and rebalance on a daily basis, they are said to maintain a constant amount of leverage. If on a given day, the value of the equity portion of the portfolio increases, then the fund has to increase leverage and exposure on that day to maintain the desired amount of leverage to equity going into the next day. Conversely, if the equity portion decreases, the fund has to sell equity or decrease leverage.
The net effect of this daily adjustment to maintain a constant leverage to equity ratio is that when the stocks of the portfolio are up, the ETF is buying more stock and when the stocks are down, the ETF is selling. The ETF ends up BUYING HIGH and SELLING LOW, which is exactly the opposite of what an investor should do to profit in the stock market. It is precisely this reason which makes the leveraged exchange traded funds useful primarily for day trading as opposed to longer term buying and holding to hedge a portfolio. Unfortunately, most investors do not understand the constant leverage trap or the dangers of the leverage ETF.
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