How would you like to turbocharge your investment returns?

I know, stupid question!

So let’s look at a vehicle which has the potential to do just that. I’m talking, of course, about leveraged ETFs.

Leveraged ETFs have been around for a while now, and get many investors curious. They advertise the potential for higher returns – all from a boring old index fund.

Sounds great, right? But despite that, they aren’t anywhere near as popular as you might think. So, what’s the deal?

In this article, we’ll explore how leveraged ETFs work, the pros and cons, performance history, and what to be aware of before adding them to your portfolio.

Because make no mistake: while these investments do have the potential for outsized gains, they aren’t for the faint of heart.

What are leveraged ETFs and how do they work?

Leveraged ETFs are similar to other broadly diversified funds. But instead of using investors’ money to purchase a big basket of stocks, a leveraged ETF will also add borrowed money to increase the size of the portfolio further.

For example, for every $1 of assets, the ETF borrows another $1, and buys $2 of assets. This allows the fund to earn gains on a larger number of dollars than it otherwise would. But if the market goes down, those losses are magnified too. More on that soon.

Leveraged ETFs in Australia seem to maintain their gearing ratio at around the 50% mark. Gearing levels are constantly monitored and adjusted by the fund manager to make sure the fund stays within an acceptable range.

Now, why would someone choose a leveraged ETF over other shares?

Higher returns. The market goes up over the long run, so using leverage can boost that return higher. Over time, that extra return can compound into a meaningful amount.

Simple use of debt. Using a leveraged ETF means the investor can benefit from leverage without the personal risk or hassle of taking on debt in their own name.

Cheaper rate. Geared funds are typically able to borrow at lower rates (wholesale) compared to what the average person can access. Less interest paid means better net returns.

If an investor buys $10,000 worth of a leveraged ETF which has a gearing ratio of 50%, the investor essentially has exposure to $20,000 worth of shares. Given the market typically goes up over time, it’s easy to see why using leverage can be appealing.

Imagine you could generate an extra 2% per annum over the long term. That could add up to some very serious coin - we’re talking hundreds of thousands of dollars.

Not only that, but some leveraged ETFs invest in broadly diversified index fund style portfolios (ASX 200 and S&P 500 for example). This means you’re getting a similar type of investment, just with amplified return potential.

Sounds pretty good, right? So why the hell doesn’t everyone do it? As with many things, there are downsides to consider.

Potential problems with leveraged ETFs

In theory, these ETFs seem like an absolute no brainer. But in practice, there’s a lot more we need to look at.

First up, there’s the volatility.

Gearing amplifies returns and losses, so when the market declines, leveraged ETFs suffer much more. Let’s use the fund ‘GEAR’ (from Betashares) as an example. This is a leveraged ETF which invests in the ASX 200.

During the covid crash in 2020, the ASX 200 fell by 36%. GEAR, on the other hand, dropped 67% (see the chart below). The orange line is the Betashares Australian geared fund, the black line is the ASX 200.

Source: Betashares

Let’s put it into dollar terms. If you had $100,000 invested in GEAR, it would’ve fallen to $33,000. In a period of just one month!

To be perfectly honest, almost nobody has the stomach for this much downside volatility. While it might just look like numbers and a chart, in reality, that represents a lot of pain. These numbers also suggest that if the market fell 50%, it’s fair to assume this leveraged ETF would be down 80% (probably more). Your $100,000 would be $20,000… or less. Yuck!

But what if this nausea-inducing volatility is worth it? Let’s check out the returns.

Performance

To deal with this kind of wild ride, we want to be well compensated. After all, any sensible investor isn’t going to put up with that for nothing!

Here’s the performance figures for the last 3 years to 28 April, 2023…

GEAR: 28.99% p.a. ASX 200: 13.99% p.a.

That’s an incredible level of outperformance. In fact, this is exactly what we’d hope for – we’re taking double the volatility, and getting basically double the downside. So in an ideal world, we’d get somewhere close to double the long term returns.

Things are looking a bit more appealing now. But this fund has actually been in operation since April of 2014. Here’s the performance since then…

GEAR: 9.50% p.a. ASX 200: 7.61% p.a.

Hmm, nowhere near as good. For completeness, here’s the performance graph since inception.

Source: Betashares

If you look carefully, you can see that up to mid/late 2022, there was zero outperformance whatsoever. Think about that for a moment.

For eight years, in an environment of positive and healthy returns, the fund generated no excess returns. Despite that, investors had to deal with much more volatility than a typical index fund.

This tells us that we should go into such an investment realising there may be long periods of underperformance and much steeper losses. And that even in an overall positive return environment, a geared ETF is unlikely to outperform as much as you’d expect. The losses seem to be magnified greater than the gains.

It depends on how the fund is run, but there are likely two causes for this. First, borrowing costs dilute positive returns but add to negative returns. Secondly, during downturns the fund has to constantly sell assets and lock in losses to maintain its gearing ratio.

This constant re-adjusting of the portfolio seems to worsen the long term outcome. The maths are explained in detail here if you’re interested.

Taxes and complexity

In some cases, leveraged ETFs also seem to pay unusually high distributions (over 10%). While that may sound great at first, it may not be.

Because the fund has to be constantly re-adjusted to manage the gearing levels, it results in more capital gains which are crystallised. These are paid out as distributions which the investor must pay tax on.

Compare this to a fund with low turnover and a buy-and-hold strategy which largely just passes on the dividends from the underlying portfolio. High tax-bracket investors will probably find this a major turn-off, as tax will eat heavily into their returns. So even if the fund beats the market before tax, after dealing with the ATO, it may be behind.

These geared funds also come with higher management fees. GEAR, for example, has a management fee of 0.80%, versus Betashares A200 fund which charges a deliciously low 0.04% per annum. But that’s fair enough, given the constant oversight required to manage debt levels and market exposure.

While these funds are a simple way to gain leveraged exposure to shares, there’s clearly some complexity going on under the hood. Given the above drawbacks, who are these funds best suited for?

Who are leveraged ETFs best suited for?

As you can probably tell by now, leveraged ETFs are not for everyone. Hell, they’re probably not even for most people.

So who are they for? What type of investor is a good fit for this type of investment?

Aggressive investors. Those who are hungry for higher-than-market returns without having to pick stocks or do any of the fiddly research to try and beat the market. By utilising debt it can magnify returns, helping an investor reach their long term wealth goals.

Those with an iron stomach. Those able to sit through sharp losses and rollercoaster volatility, while ideally even investing more during those times. That’d be the optimal way to use a leveraged ETF and outperform.

Short term traders. As a community of long term investors, this probably doesn’t apply to people reading this blog. But short term traders can benefit from making bigger than average gains if they correctly call (guess?) which direction the market is heading next.

Using a geared ETF can also suit those who want to use some form of borrowing to invest with, but either can’t or would rather not take on debt in their own name. Using home equity or margin debt to invest means you’re personally liable for the debt. But with a leveraged ETF, you aren’t liable whatsoever, even if the fund somehow fails. Because the fund is its own entity.

As for the future, we can’t know how much a leveraged ETF may outperform (or whether it definitely will). But let’s say it delivers a hypothetical 8% per year (after tax) instead of 7%. The long term impact of that outperformance would still be decent.

Let’s say we invest $10,000 and then an additional $3,000 per month for 20 years.

At 7% per annum, our wealth would grow to approximately $1.6m.

At 8% per annum, our wealth would grow to a little over $1.8m.

Nothing to be sneezed at. It could mean reaching financial independence a year or two earlier.

Summary

Leveraged ETFs are an interesting vehicle. Even though they haven’t become super popular in Australia, the potential is still there. I think once we see how they perform over longer periods (nine years is still quite young), then we may see more people become convinced.

Despite the potential for higher returns, leveraged ETFs don’t work quite as many expect them to. They have historically outperformed healthily during bull markets. But they fall by stomach-churning amounts during downturns. That’s enough to turn many people off, myself included.

I’m comfortable using leverage with my investments. But I’m not so comfortable having a large portion of my wealth exposed to such extreme volatility. Especially when that volatility is in your face on a regular basis.

As with most things relating to finances, there’s psychology involved here, not just numbers. Ultimately, it’s for the individual to decide whether the pros outweigh the cons.

Until next time, happy investing!

Dave