A leveraged ETF is an ETF that’s designed to amplify returns of standard index ETFs. Instead of tracking true performance of an index, it will generate more extreme returns.
For example, when the S&P 500 index goes up 1%, you can expect SPY, an index ETF, to also gain 1%. With a leveraged ETF like UPRO (which uses 3x leverage), when the S&P 500 goes up 1%, UPRO is expected to go up 3%. The downside is that if the S&P 500 goes down 1%, you can also expect UPRO to go down 3%. The correlation isn’t perfect due to more complex factors which we cover here, but this is how you can view leveraged ETFs at a high level.
Leveraged ETFs are generally used by more aggressive investors to generate larger returns, but due to their volatility and larger drawdowns, they’re more risky than one might prefer. It’s important to note also that not all leveraged ETFs use 3x leverage, and they don’t have to be based just on the S&P 500. SSO, for example, is a 2x leveraged ETF on the S&P 500, and LABU is a 3x leveraged ETF on the Biotechnology Select Industry Index. They also don’t have to track in the same direction, which we’ll get into more in our piece on inverse ETFs. SPXS is a leveraged inverse ETF that is designed so that when the S&P 500 goes down 1%, SPXS is expected to go up 3%.
At Composer, there are a few different ways we use leveraged ETFs in our symphonies on the Discover page. In “Risk On or Risk Off Leveraged S&P 500”, allocation is based off of the conditional: “Is the 5-day moving average of SPY is greater than the 100-day moving average of SPY?” If the answer is yes, we can view that as “Risk On” mode, as the S&P 500 has shown strength over the past few days. In Risk On mode, your portfolio is holding 100% UPRO, the 3x leveraged S&P 500 ETF mentioned above. If the answer is no, and the S&P 500 is showing signs of weakness recently, your portfolio is allocated to 100% IEF, a treasury bond ETF. By moving in and out of UPRO based on recent market movement, you can gain exposure to the leveraged returns of UPRO, while trying to avoid the larger drawdowns in riskier settings.
Looking at a backtest from January 1st, 2010 to January 1st, 2022, “Risk On or Risk Off Leveraged S&P 500” had an annualized return of 23.9%*, while just holding SPY produced an annualized return of 14.9%. Holding UPRO in this timeframe generated lofty returns of 34.7% annualized, but this came with a max drawdown of 76.8%, while “Risk On or Risk Off Leveraged S&P 500” had a max drawdown of 42.3%.