WSJ: Are Leveraged ETFs Worth the Tracking Error? (2024)

Leveraged ETFs, which aim to amplify returns through the use of futures and other derivatives, have been the go-to for investors looking to make an outsize bet on the direction of a particular index since they were launched 15 years ago.

But are these exchange-traded funds worth the relatively high costs, considering the volatility to which they are prone and the tracking error, or how much the price behavior of the investment diverges from the price behavior of its benchmark.

My research assistants, John Shaffer and Giovanni Rustici, and I examined four categories of leveraged ETF funds — those that track the S&P 500, the Dow industrials, the Nasdaq-100 or the Russell 2000 index of small stocks. We found that leveraged ETFs in three out of the four categories provide sufficient returns over the long run to justify their costs and risks, and despite persistent tracking-error divergence.

We began our research by pulling data on all leveraged ETFs that have been issued in U.S. markets over the past 10 years. We then drilled down to focus only on S&P 500 leveraged ETFs, Nasdaq leveraged ETFs, Dow leveraged ETFs and Russell 2000 leverage ETFs. We then separated them by their bull or bear construction — 3X or 2X (designed to deliver three times or two times the daily performance of the index, respectively) or -1X, -2X, -3X (designed to deliver one, two or three times the inverse of the index’s performance).

From there, we investigated the average 10-year returns to each grouping by index and how they are structured in terms of magnification (bull or bear structure). The first interesting finding is that in general, as the magnification increases the tracking error from the underlying index increases.

For example, the S&P 500 delivered an average annual return of 12.6% over the past 10 years (with dividends reinvested), while the average 2X leveraged S&P 500 ETF delivered 19.8% a year over the past 10 years. If the average leveraged ETF was actually two times the S&P 500, this would have been a 25.1% return over the past 10 years, meaning the tracking error for these investments is about 5.3 percentage points annually.

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