Leverage vs leveraged ETFs
Leverage vs leveraged ETFs
Leverage vs leveraged ETFs
@jonathan2 months ago
Leveraged ETFs vs. Margin Loans: Why Borrowing is Often Better
Leveraged ETFs, like TQQQ (3x leveraged Nasdaq-100) and UPRO (3x leveraged S&P 500), offer an easy way to amplify returns without taking on a margin loan. At first glance, they seem like a safer, simpler alternative to borrowing money to invest. However, when you compare the two approaches, margin loans often outperform leveraged ETFs over time. The reason lies in how leveraged ETFs are structured, and how their mechanics-like beta slippage, roll yield, and tracking errors-erode returns.
To illustrate, let's compare the outcomes of investing $100 using a leveraged ETF versus borrowing $100 to double your exposure to the underlying index.
The Scenario: A Volatile Market
Imagine an index starts at $100, rises 10% to $110, and then falls back 10% to $99. We'll look at the outcomes for a 3x leveraged ETF and a margin loan over these two trading days.
Leveraged ETF (3x Daily Performance)
- â Day 1: The index rises from $100 to $110 (+10%). The ETF gains 30%, so it goes from $100 to $130.
- â Day 2: The index falls from $110 to $99 (-10%). The ETF loses 30%, so it drops from $130 to $91.
After two days: The index is down 1%, but the leveraged ETF is down 9%.
Using a Margin Loan (2x Leverage)
With a margin loan, you invest $200 total-your $100 plus $100 borrowed. If the index rises 10% on Day 1, your $200 grows to $220. After Day 2, when the index falls 10%, your $220 becomes $198.
After two days: Your portfolio is down 1% , matching the index.
Why Borrowing Outperforms Leveraged ETFs
1. Beta Slippage: The Compounding Problem
Leveraged ETFs are designed to multiply the daily returns of the index, not its long-term performance. When the index rises and falls, the compounding effect works against the ETF over time, particularly in volatile markets. In our example, the ETF fell 9% while the index fell only 1%, a dramatic divergence caused by this daily compounding effect. With a margin loan, your returns directly track the index's performance, so you avoid this slippage.
- â Leveraged ETFs amplify daily returns but suffer from beta slippage, roll yield costs, and tracking errors that erode returns over time.
- â Margin loans track the underlying asset's performance directly, avoiding these issues and often delivering superior results.
- â Borrowing money to invest may seem riskier, but in reality, it offers more predictable outcomes and fewer hidden costs than leveraged ETFs.
2. No Roll Yield Costs
Leveraged ETFs often use derivatives like futures contracts to achieve their leverage.
These contracts must be 'rolled' when they expire, and if the futures market is in contango (where future prices are higher than spot prices), the fund incurs a cost known as negative roll yield. This drag doesn't exist when you borrow money directly to invest.
3. Fewer Tracking Errors
Leveraged ETFs aim to replicate a multiple of the index's daily return, but their performance can deviate due to fees, liquidity issues, and rebalancing costs. These tracking errors add up over time, further reducing returns. A margin loan has no such issues-you simply hold the underlying asset and track its performance precisely.
4. Lower Ongoing Costs
Leveraged ETFs typically have higher expense ratios, often exceeding 1%. Meanwhile, the cost of a margin loan is simply the interest rate on the borrowed funds. In a low-interest-rate environment, this cost can be significantly lower than the fees embedded in leveraged ETFs.
Key Takeaways
Leveraged ETFs can still be useful for short-term trades or specific hedging strategies. However, if your goal is to amplify returns over longer periods, borrowing money to invest directly in the underlying asset is usually a better approach. By eliminating the structural inefficiencies of leveraged ETFs, you can maximize your returns while minimizing surprises.
Always remember: leverage amplifies both gains and losses, so only use it if you fully understand the risks and have the discipline to manage it responsibly.


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