Building Wealth Through Leveraged ETFs – Avoiding Ruin On The Way There. (NASDAQ:TQQQ) – Seeking Alpha
Why use leverage? Leverage has always been the most effective way to build wealth. It also has been the most potent way to destroy it. Hence the bad name attached to it, from the disrepute attached to 3X leveraged ETFs to the fatherly advice Warren Buffett freely dispenses. Here’s what the Sage of Omaha said in his 2010 shareholders letter: “History tells us that leverage all too often produces zeroes, even when it is employed by very smart people.” I tend to watch what Warren does rather than listen to what he says, as this advice coming from someone running an insurance company always sounded bizarre to me: who can possibly rely more on other people’s money (OPM) than an insurer? “Do as I say, not as I do”…
As we know, real estate has always been the most effective way to build riches, the main reason being that all the real estate moguls have been masters of leverage. Same can be said about bankers and hedge fund managers. But what about you and me? Thankfully, this bad rap does not extend to leverage through mortgage financing, good source of wealth creation, accessible to all. But as the 2008 GFC demonstrated, this leverage too did produce zeroes, and even worse, for underwater homeowners. Leverage is a powerful tool when used smartly, but as all tools, if misused, it can lead to disastrous outcomes. This article aims at clarifying how and when to use it and when to shun it to build wealth over time while steering clear of its potentially toxic effects.
How to use leverage? Leverage for individual investors comes in three main forms: futures contracts, margin accounts and leveraged ETFs (LETFs). The first two are aimed at “accredited investors”, who supposedly know what they are doing, while leveraged ETFs are directed at retail investors, providing easy access to leverage through a ready-made (if somewhat costly) product. We will focus here on Leveraged ETFs but the rules defined -eliminate leverage when market conditions change- apply to all forms of leverage.
Do Leveraged ETFs deserve their bad rap? This bad rap is built on the fact that LETFs suffer from what is called “volatility decay”. The typical demonstration shows that in a flat market, whereas the unlevered product will have returned to its original level, the LETF will end the period below that level. Similarly, in a bear market, the LETF will experience a larger loss than the unlevered product. But conversely, in a bull market, compounding will run its magic and propel the LETF way above its unlevered kin. So there is indeed volatility decay, but …….