Leveraged ETFs have gained immense popularity in recent years, promising amplified returns for traders looking to capitalize on daily market movements. However, these products come with significant risks that many investors fail to fully appreciate. Understanding how leveraged ETFs function and the dangers they pose is crucial before considering them in any portfolio.
Leveraged ETFs typically offer 2x or 3x exposure to an index’s daily performance. The key word here is "daily"—a 3x ETF does not mean an investor will get three times the return of an index over a longer period. Due to severe drawdowns and volatility decay, the long-term performance of leveraged ETFs often diverges significantly from expectations and short-term timing can become critical to the success of the investment.
Interest in leveraged ETFs has never been higher than it is today. Assets under management for U.S. leveraged ETFs reached a record of about $120 billion in November 2024.
Timing and Market Trends: When Leveraged ETFs Launch
Issuers tend to launch leveraged ETFs during periods of strong momentum in a specific market segment. This often coincides with heightened investor enthusiasm and peak valuations, meaning that many of these ETFs attract investors at precisely the wrong time—just before momentum reverses.
Another key consideration is the cost of holding these products. Many leveraged ETFs carry high expense ratios—such as NVDL, a 2x leveraged ETF tracking NVIDIA (NVDA), which charges 1.06% per year on the underlying assets under management. These fees add up over time, further eroding returns for long-term holders. Meanwhile, issuers benefit from increased trading activity and fees, regardless of outcome.
Let’s look at an example. Say someone invested in a hypothetical 2X or 3X Russell 1000 Growth Index ETF on 1/2/1997. They would’ve enjoyed strong relative performance vs. the unleveraged index until 4/5/2002. Following the Dot Com crash, an investor wouldn’t have seen their 2X ETF get back to even with the unlevered index until a brief stint from 10/4/2006 – 9/2/2008. Then, following the Financial Crisis of 2008, the 2X would’ve underperformed the index until the beginning of 2013. The 3X ETF is even worse, as an investor would’ve dipped below the unleveraged index on 7/5/2001 and wouldn’t have made it back to even with the index until 12/8/2016.
Single-Stock Leveraged ETFs
Leveraged ETFs tracking individual stocks introduce even greater risks. To illustrate, consider Microsoft 2X and Cisco 2X vs. their unleveraged stock prices before and after the dot-com bubble. Had someone invested in both on 1/2/1997, 2X Microsoft would’ve lost its relative outperformance on 4/26/2002, while Cisco would’ve lost its relative outperformance on 2/27/2001. 2X Microsoft would have experienced a brief return to relative outperformance (58 trading days from 10/26/2007 – 1/18/2008) before returning to underperformance until 7/20/2016. Conversely, 2X Cisco would still not have recovered to relative outperformance.
Gains Quickly Erased
The speed at which gains are wiped out is notable in both leveraged individual stocks and leveraged indices. The 2X levered Microsoft would have reached $18.83 on 3/23/2000 (from an initial investment of $1), before dropping 72.4% in 46 trading days to $5.19 on 5/26/2000. As noted previously, it took until 4/26/2002 for the hypothetical 2X ETF to drop below the unleveraged stock. At its peak, the 2X ETF would have reached $22.39 on 12/27/1999. At its bottom, it would have reached $0.63 on 3/9/2009.
Similarly, the hypothetical Russell 1000 Growth levered indices (2X and 3X) would have experienced a swift loss of gains following the Dot Com crash. Each levered index hit a peak on 3/23/2000, the 2X at $6.09 and the 3X at $11.84. From its peak, the 2X 1000 Growth would go on to drop 77.8% from 3/23/2000 to its loss of relative outperformance on 9/7/2001 when it reached $1.35. The 3X 1000 Growth would go on to drop 86.8% from 3/23/2000 to its loss of relative outperformance on 7/5/2001 when it reached $1.57. Each hit their bottom on 3/5/2009, the 2X at $0.48 and the 3X at $0.12.
Final Thoughts
Leveraged ETFs are really designed for short-term traders, not long-term investors. Their structure makes them susceptible to volatility decay, high fees, and amplified losses during market downturns. While they can offer substantial gains in the right conditions, they require active monitoring and a deep understanding of their mechanics.
To understand volatility decay and the nature of these leveraged ETFs, let’s look at the analysis of rolling periods where the hypothetical 2X and 3X Russell 3000 Growth ETFs actually deliver their expected multiples of return. Notably, they never achieve this 100% of the time. While many investors assume these ETFs consistently provide the enhanced returns advertised, in reality, they often fall short, and underperform their intended targets. Outside of the 3- and 5-year time periods, it is basically a coin flip or worse whether or not you actually get the 2x or 3x returns.
Before investing in a leveraged ETF, investors should ask themselves: Am I prepared to actively manage this position? Do I understand the impact of daily resets and compounding? How much of my portfolio am I willing to risk in an ETF that could have massive downside? History has shown, these products tend to thrive in hot markets but can quickly turn into wealth-destroying traps once momentum fades.
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