ETFs & Funds
Leveraged and Inverse ETFs: Why They Decay Over Time
A 3x fund promises three times the index for one day. Over a choppy week the arithmetic produces something quite different, and here it is written out day by day.
An index falls 5%, rises 5%, falls 5%, rises 5%, falls 5%. Five sessions, down 5.47%. A 3x fund tracking that same index ends the week down 18.78%. More than three times the index loss. Nothing went wrong and nobody made a mistake. The product did exactly what its prospectus promised.
A 3x leveraged ETF aims to deliver three times an index’s return for one trading day, and everything below follows from those last four words.
The week, day by day
Both start at 100, and the two right-hand columns are the ones to watch.
| Day | Index move | 3x fund move | Index value | 3x fund value |
|---|---|---|---|---|
| Start | 100.00 | 100.00 | ||
| 1 | -5% | -15% | 95.00 | 85.00 |
| 2 | +5% | +15% | 99.75 | 97.75 |
| 3 | -5% | -15% | 94.76 | 83.09 |
| 4 | +5% | +15% | 99.50 | 95.55 |
| 5 | -5% | -15% | 94.53 | 81.22 |
Day 2 shows the mechanism. The index rose 5%, from 95.00 to 99.75. The fund rose 15%, correctly,
on a base of 85.00, so 85.00 x 1.15 = 97.75. The percentage was right. The base had already
shrunk.
Three times the index’s weekly loss would be 16.41%. The fund lost 18.78%. Those extra 2.37 percentage points are volatility decay, and they came from nothing except the order in which the moves arrived.
Why the reset does that
A regular ETF holds securities and lets them compound. A leveraged fund holds a target exposure and resizes it every evening, so tomorrow starts at exactly the stated multiple of tomorrow’s opening assets.
With $100 of assets and a 3x mandate the fund holds $300 of exposure, usually through total return swaps and index futures, and when the index rises 2% the exposure gains $6, assets become $106, the target exposure becomes $318, and the fund buys more overnight. Had the index fallen 2%, assets would be $94, the target $282, and the fund would have sold.
That is a rule which buys after strength and sells after weakness, executed every single night with no discretion and no view about whether it is a sensible moment to be doing either.
The effect cuts in your favor too. That is what keeps people in them. Take a steady climb of 2% a
day for five days. The index reaches 100 x 1.02^5 = 110.41, a gain of 10.41%. The 3x fund
reaches 100 x 1.06^5 = 133.82, a gain of 33.82%, against the 31.22% that three times the index
return would have given. A straight line makes compounding leverage your friend. The path decides
everything. Nobody knows the path in advance.
The same machinery in reverse
An inverse fund targets the opposite daily move. Run that same choppy week through a -1x fund and it finishes at 104.48 while the index sits at 94.53, down 5.47%. The mirror image would have paid you 5.47%. You got 4.48%.
Which makes inverse funds a poor long-term hedge. Buy one and hold it through a sideways, jumpy market and it loses money slowly, month after month, while the thing you were hedging ends up within a point of where it started. A -3x fund compounds the problem and adds an unpleasant asymmetry: after a large adverse move the fund’s assets have shrunk so far that a recovery in your favor rebuilds very little of what you lost.
Three layers of cost
The expense ratio typically sits near 0.90% to 1.00%, roughly thirty times what a broad index fund charges, and what that alone does to a balance over years is laid out in expense ratios explained.
Financing is the bigger layer. A 3x fund holds $3 of exposure per $1 of assets, so $2 per dollar
is borrowed in economic terms, priced into the swaps. With short-term rates at 5% the drag runs
about 2 x 5% = 10% a year. When short rates sat near zero these products carried almost no
financing cost at all, which flattered them through the 2010s and made the arithmetic look far
kinder than it is when rates are higher.
The daily rebalance costs something too. The fund trades futures and resets swaps every evening. In violent markets it is trading size at the least convenient moment of the day.
Who they are actually for
Traders holding a position for hours or a couple of days, sized so a 3x move is survivable. Over one session the fund does what the label says. The decay is negligible.
Institutions adjusting exposure briefly, for example to stay invested while cash settles.
For anyone building wealth over decades, this is the wrong tool, and I would say that plainly to anyone who asked. Taking more risk over a long horizon means more money in ordinary stock funds, which is the subject of asset allocation, because these funds start every year already behind by roughly 10% and have to climb that far before they do anything for you.
Where people get hurt
They see a fund down 60% while the index is down 25%. They expect a rebound three times as fast. It will not. From a base of 40, tripling the index’s recovery still leaves a very long way back, and the drawdown recovery calculator shows how brutally that arithmetic works against you.
They hold an inverse fund as portfolio insurance for months, paying decay the whole time, and discover it barely helped during the decline they bought it for.
They reach for single-stock leveraged funds, or leveraged versions of the concentrated baskets described in sector ETFs, where the underlying volatility runs far higher than a broad index. Since the decay term grows with the square of volatility, a stock at 50% annual volatility produces roughly six times the drag of an index at 20%.
They treat these as risk management tools. Position sizing and measuring portfolio risk do that job.
Frequently asked questions
What is a leveraged ETF?
It is a fund that aims to deliver a multiple of an index's return over a single trading day, commonly two or three times. It achieves that with swaps and futures rather than by borrowing to buy stocks. The objective resets at the end of every trading day, which is what makes the multi-day result differ from the multiple you expect.
Why do leveraged ETFs lose money over time?
Because the exposure is rebalanced to the target multiple every evening, so each day's percentage move is applied to the previous day's ending value. In a choppy market the fund sells into weakness and buys into strength every night, which compounds losses faster than gains. The effect is called volatility decay and it grows with the square of volatility.
Can you hold a leveraged ETF long term?
The prospectus of every one of these funds says the objective applies to a single day and that results over longer periods will differ, often substantially. In a steady trend a leveraged fund can beat its stated multiple, and in a choppy market it can lose money while the index is flat. Holding one for months is a bet on low volatility as much as on direction.
How does an inverse ETF work?
It aims to return the opposite of the index for one trading day, so a 1% index fall should produce a 1% fund gain. It uses short futures and swaps to do this, and it resets daily like a leveraged fund. Over multiple days an inverse fund typically delivers less than the mirror image of the index return.
What do leveraged ETFs cost?
The expense ratio is usually around 0.90% to 1.00%, which is high on its own. The larger cost is financing: a 3x fund holds three dollars of exposure per dollar of assets and funds two of them at short-term rates. If overnight rates sit at 5%, that funding alone runs roughly 10% a year before the expense ratio.