What’s the Catch with Leveraged ETFs?

Leveraged ETFs sound exciting; triple the gains, right? Not so fast. In this episode, we unpack the hidden risks, daily compounding effects, and why timing matters more than ever. Whether you’re curious about hedging, short-term plays, or just want to know if these tools belong in your portfolio, this conversation will give you the clarity you need.

Summary – IBKR Podcasts Ep. 320

The following is a summary of a live audio recording and may contain errors in spelling or grammar. Although IBKR has edited for clarity no material changes have been made.

Andrew Wilkinson

Some of this year’s best-performing equities aren’t those of individual companies. Instead, they are exchange-traded funds that magnify the performance of an underlying equity. In other words, if the price of the underlying stock moves up a dollar, the price of the ETF instrument moves up by one, two, or three times, depending on the leverage factor. 

And in the opposite style, there are funds that track the inverse performance of the underlying. Should the company share price rise by a dollar, the ETF is designed to fall by one, two, or three dollars. Not so useful when prices are rising, but very useful when prices are falling. With me to dig into the benefits and the drawbacks of the world of inverse and leveraged ETFs is Ed Egilinsky, who is the Managing Director of Direxion Funds, an ETF company that is a significant provider within that industry. 

Welcome, Ed Egilinsky. How are you? 

Edward Egilinsky

Good. Good to see you. 

Andrew Wilkinson 

Now, Ed, what exactly are inverse and leveraged ETFs for the audience, and how do they differ from traditional ETFs or mutual funds? 

Edward Egilinsky 

Well, you did a great job in your intro there—I might have to travel with you. But leveraged and inverse ETFs are designed for short-term active trading, and I think you see significant daily turnover of assets and high volume with our products. And that denotes that this allows traders to express a magnified bullish or bearish view, as you mentioned, on broad industry sectors, broader indexes, and individual stocks as well. The leverage points will range from 3x in our case to inverse 1x, and the key is within the name of overall leveraged inverse ETFs. It includes the leverage point, the word “daily”—we’ll discuss that later—and the benchmark single stock it seeks to track. And the bottom line, Andrew: these are high-risk/reward vehicles, so not gonna be for everybody. 

Andrew Wilkinson

Okay. Let’s dig down into that. Why are those ETFs then typically designed for single-day performance, and what happens when investors hold them longer? 

Edward Egilinsky

Well, the objective is to seek to track the leverage point for a given single day. Once you hold these past one day, there’s gonna be something called compounding, and the leverage could work for or against you. So the trend is your friend. If your timing is wrong, you could have excessive losses. So let’s take a simple two-day example. I have $100 and I have a 3x bull fund. And for two days in a row, that underlying index goes up 5% each day. So you made 15% each day. But due to compounding, you are gonna be above that $130 mark after two days. 

The flip side is if you have a two-day period where a 3x bull fund has the underlying index up 5% the first day, down 5% the second day. Ideally, you’d think you’d be back to your initial $100, but because of compounding, you are actually below your initial investment after two days and you’re at $97.75, so you’re actually down. So I think those are two simple examples of when the trend works for you two days in a row and when it’s choppy, where you have the index go up and down the same amount on consecutive days—that you’re below your initial investment in that example. 

Andrew Wilkinson 

All right, so talk about the tactical strategies where these products shine, such as hedging, short-term speculation, or volatility plays. 

Edward Egilinsky

Well, certainly you could trade off headlines. We have a lot of people do that based on geopolitical risks, macro events. So China comes to mind, for example—leveraged bull/bear on the FTSE China 50. Earnings: we just got out of the main earnings season; people trade off pre- and post-earnings. The “Mag Seven” come to mind, of course—a lot of them reported last week, some with mixed results. So we have leveraged single stock where you could do a 2x bull or a non-leveraged inverse bear. And then we have economic data, albeit that right now the government shutdown means not a lot of data points that you would normally have. Fed meetings: we see a lot of trading in our leveraged Financial Select Sector Index, as well as the 20+ Year Treasury Bull and Bear—those are very popular. What’s going on right now with U.S.–China? Seems like something’s always going on, especially with trade negotiations, government regulation—potentially with the semis and software—so you could trade those leveraged bull and bear products. 

Spikes in the VIX: we’re seeing that more recently now. It’s been very complacent in terms of the marketplace since really you had the 90-day moratorium post-Liberation Day. So for people that want to take a magnified short-term view: on a bullish side, you don’t need margin. With this, it’s an ETF—your liability is limited to your initial investment. And for those that feel the market might go down or wanna take a short-term bearish view, here’s a way to do it in an inverse fund without having unlimited risk. 

Now you mentioned hedging. You’ve had tremendous run-ups in a number of the Mag Seven. You may want to use an inverse type of single stock to maybe hedge some gains there at times. However, you’re gonna need to rebalance periodically to maintain that whatever net long exposure that you want. So these are useful trading tools. You can trade off headlines or you can trade off technicals, but the key is you gotta monitor these on a day-to-day basis. 

Andrew Wilkinson

Are there any misconceptions—common misconceptions—amongst retail investors about inverse and leveraged ETFs? 

Edward Egilinsky

You can hold these indefinitely—that you’re gonna get a 2x or 3x cumulative return over a period of time when you hold them. So there’s a lack of understanding in terms of the compounding impact and that the timing matters—not monitoring these on a daily basis. You can’t set and forget these vehicles. And most people, although they understand the risk, until you lose a significant amount of money, if you’re on the wrong side of a trade you wanna make sure that whatever you are risking, you can afford to lose. 

Andrew Wilkinson

But what about the recent trends? It’s been a very interesting year. What about the recent trends in ETF flows or investor behavior that suggest increased or decreased interest in these products? 

Edward Egilinsky

Well, certainly there’s been a big focus on tech—semis, AI. But also you’ve had a tremendous move in gold and gold miners. People are trying to predict the next interest rate move. The Fed says they’re gonna cut, but who knows? So we’re seeing a lot of activity there. But it’s interesting—we have seen a lot of outflows in our bull funds. And a large part of that is due to profit-taking, you would hope. And we’re seeing a lot of inflows in bear funds where people are trying to look for a reversal, think things are overextended. But the bulls have been winning out the last couple of months for sure. But it tends to be counterintuitive—our flows—when the market’s doing real well in certain sectors or broader market. We’ll see selling into that strength. And then you’ll see some inflows into bear funds. All of our outflows year-to-date so far—the top 10—are all bull funds. 

On the flip side, the inflows year-to-date—what’s interesting—there’ve been some underperforming sectors, Andrew, like homebuilders, for example. So we’re seeing inflows there. Tesla, despite the fact it’s rallied the last couple of months—we had sizable inflows the first couple of months of the year where it was underperforming. So we have seen some inflows for the most part in bear funds. There have been some exceptions, like regional banks and homebuilders, and some of the single stocks, which I mentioned. 

Andrew Wilkinson 

What should investors ask themselves before using inverse and leveraged ETFs in their portfolio? Ed? 

Edward Egilinsky

If they can handle the risk, that they understand the mechanisms of how leveraged and inverse ETFs work—which is some of the things we touched on today. Those are the key elements there. And if they have a high risk tolerance at the end of the day. So these shouldn’t be traded by everyone. They’re only for those short-term active traders that are really monitoring their trading on a day-to-day basis. And for those individuals that might be using options, futures, crypto, or probability contracts—those tend to be the same type of traders that gravitate toward leveraged and inverse. 

Andrew Wilkinson

How can platforms and educators help investors better understand the nuances of these tools, Ed?

Edward Egilinsky

Yeah, well, Interactive Brokers—we’ve partnered with you, Andrew, and it’s a testament to you and your team there. The Trader Academy and the interactivebrokers.com campus have great educational resources, including videos on how leveraged and inverse ETFs work. Direxion has a dedicated educational section within our website regarding leveraged and inverse ETFs, and they certainly can go to our website at direxion.com for more details. 

Andrew Wilkinson

And we’ll put that link into the show notes. Ed Egilinsky, Managing Director at Direxion—thank you very much for joining me today. 

Edward Egilinsky 

Thanks for having me. 

Andrew Wilkinson 

Alright, and if you enjoyed today’s podcast, please remember to subscribe wherever you download your podcasts from. Bye for now.