Do Leveraged and Inverse ETFs Converge to Zero? (2024)

FAQs

Do Leveraged and Inverse ETFs Converge to Zero? ›

We use the concept of a growth optimized portfolio to show that highly levered ETFs (3x and inverse ETFs) are likely to converge to zero over longer time horizons.

Leveraged ETF prices tend to decay over time, and triple leverage will tend to decay at a faster rate than 2x leverage. As a result, they can tend toward zero.

This shows that the potential for both profit and loss can be magnified with leveraged inverse ETFs. It is also important to note that leverage also means it is possible that a leveraged inverse ETF can go to zero or near zero with a large enough daily move in the price of the underlying asset or index.

Yes, an inverse ETF can reach zero, particularly over long periods. Market volatility, compounding effects, and fund management concerns can exacerbate losses. To successfully manage possible risks, investors should be aware of the short-term nature of these securities and carefully monitor their holdings.

In other words, you could potentially be liable for more than you invested because you bought the position on leverage. But can a leveraged ETF go negative? No. If you own a leveraged ETF you can't lose more than your initial investment amount.

Over the long-term, inverse ETFs with high levels of leverage, i.e., the funds that deliver three times the opposite returns, tend to converge to zero (Carver 2009 ).

"They all go to 0 over time." "If you hold them for more than a few days, you will lose money." The 3x Long Nasdaq 100 ETF (TQQQ) was launched in February 2010, over 8 years ago. Since its inception, it has advanced 4,357%, versus a gain of 378% for the unleveraged Nasdaq 100 ETF (QQQ).

Investors who wish to hold inverse ETFs for periods exceeding one day must actively manage and rebalance their positions to mitigate compounding risk. The effect of compounding returns becomes more conspicuous during periods of high market turbulence.

"Leveraged and inverse funds generally aren't meant to be held for longer than a day, and some types of leveraged and inverse ETFs tend to lose the majority of their value over time," Doak explained.

Bottom Line on Leveraged ETFs

Leveraged ETFs decay due to the compounding effect of daily returns, volatility of the market and the cost of leverage. The volatility drag of leveraged ETFs means that losses in the ETF can be magnified over time and they are not suitable for long-term investments.

How long should you hold a leveraged ETF? ›

The daily rebalancing of leveraged and inverse ETFs creates a situation that for periods longer than a day or two the return of a leveraged or inverse ETF will deviate from the margin account benchmark.

If you buy an inverse ETF and the market associated with your fund rises, you will lose money. If the fund is leveraged, you could experience dramatic losses. Market downturns and bear markets are entirely different than rising markets.

The Bottom Line. Yes, you can short ETFs. Short selling ETFs aims to provide returns that move in the opposite direction of a specific underlying index or asset class. This strategy is suitable for investors seeking to hedge against market downturns or capitalize on bearish market trends.

This implies that given these assumptions and enough time, the value of an investment in leveraged and inverse ETFs will eventually converge to zero with near certainty.

Leveraged ETFs amplify daily returns and can help traders generate outsized returns and hedge against potential losses. A leveraged ETF's amplified daily returns can trigger steep losses in short periods of time, and a leveraged ETF can lose most or all of its value.

Volatility of Leveraged ETF

Another leveraged ETF risk is the leveraged ETF volatility. Maintaining a constant leverage ratio that is probably two or three times the usual amount is typically hard. The price of the underlying index fluctuates, changing the leveraged funds' assets value, depicting high volatility.

Bottom Line on Leveraged ETFs

Leveraged ETFs decay due to the compounding effect of daily returns, volatility of the market and the cost of leverage. The volatility drag of leveraged ETFs means that losses in the ETF can be magnified over time and they are not suitable for long-term investments.

The daily rebalancing of leveraged and inverse ETFs creates a situation that for periods longer than a day or two the return of a leveraged or inverse ETF will deviate from the margin account benchmark.

Most leveraged and inverse ETFs reset each day, which means they are designed to achieve their stated objective on a daily basis. With the effects of compounding, over longer timeframes the results can differ significantly from their objective.