Disclaimer: The information in this article is intended for informational purposes only and should not be taken as personal financial advice.
Introduction
Leveraged exchange-traded funds (ETFs) are designed to deliver 2x, 3x, or even 4x the daily returns of an underlying asset! While the prospect of amplified gains is appealing, many investors are surprised to find that these funds often underperform the assets they track over time.
The reason? A phenomenon known as leveraged ETF decay.
How does this decay occur, and does it affect all leveraged ETFs? Let’s dive into the mechanics and uncover the key factors that impact these high-risk, high-reward investments.
How Does Leveraged ETF Decay Occur?
Decay occurs when a leveraged ETF loses value over time, even when the underlying asset it tracks does not lose any of its value.
The root cause of decay is simply in the math behind percentage losses. Recovering from a loss always requires a greater percentage gain to break even.
For example, a 50% loss will require a 100% gain to return your breakeven value. In leveraged ETFs, the compounding effect significantly amplifies this challenge, making it harder to maintain long-term value.
Understanding the Math Behind Leveraged ETF Decay
To fully understand how leveraged ETF decay works, let’s look at two simple examples.
Example 1: Larger Price Movements
- Day 1: The underlying asset starts at $100 and gains 10%, closing at $110.
- A 3x leveraged ETF would rise by 30%, ending at $130.
- Day 2: The underlying asset drops by 9.1%, returning to $100.
- The 3x leveraged ETF would lose 27.3%, ending at $94.61.
Despite the underlying asset returning to its original value, the leveraged ETF has lost over 5% of its value! Now let’s look at an example with lower volatility.
Example 2: Smaller Price Movements
- Day 1: The underlying asset starts at $100 and gains 1%, closing at $101.
- A 3x leveraged ETF would rise by 3%, ending at $103.
- Day 2: The underlying asset drops by 0.99%, returning to $100.
- The 3x leveraged ETF would lose 2.97%, ending at $99.94.
Even with smaller daily movements, decay is still present, although significantly less pronounced compared to larger price fluctuations.
The Impact of Volatility
The examples above show how leveraged ETFs that track volatile assets, such as foreign markets or commodities, are much more susceptible to decay. Large daily swings in price can lead to a gradual decay of value, even though the underlying asset is moving in a favorable direction over the long term.
On the other hand, leveraged ETFs that track low-volatility, consistently growing assets, such as SPY or QQQ, are better at avoiding decay and have a higher chance of outperforming in the long term.
Do All Leveraged ETFs Decay?
By nature, all leveraged ETFs are subject to decay whenever the underlying asset experiences a price drop. However, the extent of decay depends heavily on the magnitude and frequency of these price movements.
Certain leveraged ETFs are better at avoiding significant long-term decay and, in some cases, can significantly outperform their underlying assets. This resilience is often attributed to the compounding benefits of leverage.
Comparing Leveraged ETFs
Below is a table comparing the returns of US vs Foreign leveraged ETFs over the last 10 years (2015-2025):
| Underlying Asset | Leveraged ETF | 10-Year Return (Underlying) | 10-Year Return (Leveraged) |
|---|---|---|---|
| S&P 500 | SPXL | +194% | +743% |
| NASDAQ 100 | TQQQ | +407% | +1977% |
| FTSE Developed Europe All Cap Index | EURL | +43% | -20% |
| FTSE China 50 Index | YINN | -11% | -95% |
It’s clear that leveraged ETFs tracking historically stable U.S. indices like SPXL and TQQQ performed incredibly well due to low volatility and steady growth. On the other hand, EURL and YINN, which track volatile foreign markets, faced significant losses due to compounding decay.
Conclusion
The statement that “all leveraged ETFs decay” is technically true but can be misleading. As we’ve seen, volatility plays a crucial role in determining the extent of decay.
Leveraged ETFs tracking consistently growing, low-volatility assets tend to experience minimal decay and can even outperform their underlying benchmarks due to compounding benefits. These types of leveraged ETFs can be viable high-risk investments for both short and long-term strategies.
On the other hand, leveraged ETFs tracking high-volatility or poorly performing assets are deeply affected by decay. Such funds should only be considered for short-term investments or avoided altogether.
Understanding the dynamics of decay and the role of volatility can help you make more informed decisions when navigating the high-risk, high-reward world of leveraged ETFs
Happy Investing!
