From "2x Long" to "Inverse Down," are Leveraged ETFs "Misleading"?

A 2x leveraged ETF tracking MicroStrategy has plummeted 65% over the past 12 months, while the company's stock price has risen 28% during the same period, highlighting the issue of "volatility decay."

For investors eager to achieve higher returns in a record bull market, leveraged ETFs were once seen as a shortcut. As of mid-October, the asset size of leveraged single-stock ETFs has grown to approximately $40 billion.

However, the rapid expansion of these products is causing more investors to face unexpected losses, especially those who misunderstand how leveraged funds operate. According to Morningstar data, traders withdrew nearly $5 billion from leveraged single-stock funds over the past two quarters, marking the first outflow for this category.

Meanwhile, ETF issuer Volatility Shares submitted documents last week to launch 27 high-leverage ETFs, including what may become the first 5x leveraged funds in the U.S.

The U.S. Securities and Exchange Commission had previously expressed opposition to high-leverage funds, but due to the suspension of fund application reviews during the government shutdown, these products may be automatically approved for issuance 75 days after application.

How Leverage Mechanisms "Devour" Returns

The fundamental reason why leveraged ETFs diverge from the long-term performance of their underlying assets lies in their "daily compounding" operational mechanism, which leads to what traders call "volatility decay."

The most common type of leveraged ETF aims to achieve 2x returns on the underlying asset. For example, a 2x leveraged ETF tracking Tesla would rise 10% on a day when Tesla rises 5%, but if Tesla falls 5%, the ETF would plummet 10%.

However, these funds are designed to provide a specific multiple (such as 2x) of "daily" returns, not long-term returns.

For instance, suppose a stock and its 2x leveraged ETF both start at a price of $10:

• On the first day, the stock drops 30% to $7, while the leveraged ETF falls 60% to $4.
• On the second day, the stock rebounds strongly by 50%, rising to $10.5, achieving a weekly gain.
• But for the leveraged ETF, even if it also achieves a 100% increase (which is double the stock's 50% rise), its price can only recover from $4 to $8, still resulting in a weekly loss.

The greater the volatility of the stock, the more easily the long-term returns of the leveraged ETF are eroded. As Dave Nadig, research director at ETF.com, stated:

The more leverage or volatility you add to these funds, the more pronounced all their problems become.

Fund managers also generally warn that these products should not be held for the long term.

The Painful Lesson for Investors: "Are We Done For?"

For many retail investors attracted by the get-rich-quick stories on social media and who have a limited understanding of the operational mechanisms, this mathematical trap has resulted in significant actual losses.

Tracking two 2x leveraged ETFs of MicroStrategy is an extreme example, as their surge last year drew attention on social media, attracting a large influx of thrill-seeking investors at an unprecedented pace.

Now, despite the underlying stock itself rising, many investors are facing huge losses.

On Reddit's investment forum, a user desperately posted:

Are we holders of MSTU and MSTX (the codes for the two MicroStrategy leveraged ETFs) done for?

Another investor discussing these funds wrote:

If I didn't understand price decay before, I understand it now. I've learned my lesson and don't plan to touch leveraged ETFs again.

High Fees Drive Surge in Supply

Although large management firms like BlackRock and JP Morgan Asset Management have avoided these types of ETFs due to risk considerations, many other institutions are attracted by the hefty management fees.

Leveraged ETFs typically charge about 1% in asset management fees, significantly higher than the average rate of 0.3% for actively managed funds.

According to data from Bank of America analysts, around 200 leveraged stock ETFs are set to launch in 2025 alone, bringing the total to 701 by October. As of mid-October, the asset size of leveraged single-stock ETFs has reached approximately $40 billion.

Asset management firms have not been deterred by investor losses. Some institutions continue to launch leveraged ETFs, attempting to profit from investors encouraged by the recent market rally.

If regulators fail to act within the 75-day application period, extreme products, including the first batch of 5x leveraged funds, may be approved for issuance. Analysts point out that such funds can go to zero and be liquidated when the underlying stock drops 20% in a single day.

Risk Warning and Disclaimer

The market is risky, and investment requires caution. This article does not constitute personal investment advice and does not take into account the specific investment goals, financial situation, or needs of individual users. Users should consider whether any opinions, views, or conclusions in this article align with their specific circumstances. Investing based on this is at one's own risk