Leveraged ETFs: Benefits, Risks, and How Daily Resets Really Work

An investment of $10,000 in the ProShares UltraPro S&P 500 3x leveraged ETF at its 2009 launch would now be worth $1.3 million, significantly outperforming a regular S&P 500 ETF. Leverage, which involves using financing to gain asset exposure beyond one's equity, can be a strategic component of asset allocation but also carries substantial risks. Leveraged ETFs offer a direct way to achieve leveraged exposure to stocks.

Understanding Leverage and Its Implications

Leverage amplifies asset exposure for each dollar invested. For instance, $1,000 invested in a 2x leveraged index ETF provides exposure to $2,000 of the index's daily returns. While this can lead to significant upside, it also increases volatility and can impact returns based on the cost of leverage and the underlying asset's performance.

The decision to use leverage is akin to choosing between stocks and bonds; it depends on individual circumstances. A key theoretical argument for leverage suggests that young individuals with high human capital (future earnings potential) and low financial wealth should borrow to invest. This is because their human capital can be viewed as a large, safe bond, making their overall early-life asset allocation concentrated in safe assets. Borrowing to invest in stocks would then balance their portfolio by adding exposure to risky assets. This concept was formalized by Paul Samuelson and Robert Merton and further refined in subsequent research, which treated human capital as an asset in the portfolio.

The optimal use of leverage increases if one's labor supply is flexible, allowing for stable income even during market downturns. Conversely, if income is highly correlated with the stock market, less leverage is advisable. This aligns with the question: "Are you a stock or a bond?" If human capital is stock-like, less risk should be taken in financial markets; if it's bond-like, more risk can be afforded.

Cautions Regarding Human Capital and Leverage

The assumption of "safe" human capital needs careful consideration. Young people, in particular, may have riskier human capital. Evidence suggests that many high-income households experience declines in wage and business incomes concurrently with stock market downturns. This often leads them to sell liquid assets, including stocks, to cover fixed expenses like mortgages or daycare, resulting in selling after prices have fallen. This highlights the importance of carefully evaluating the safety of one's human capital before applying leverage strategies.

A 2013 paper, "Diversification Across Time," supports leverage for young investors, suggesting 2x leverage early on, gradually decreasing towards retirement. This strategy, when compared to a non-leveraged constant allocation, showed similar mean retirement accumulation but with higher standard deviation of retirement wealth for the non-leveraged approach. However, this research also assumes human capital is a bond-like asset, which may not always hold true, especially for younger individuals.

The target allocation in such models is often defined by the Merton-Samuelson share, which considers the equity risk premium, variance of stock returns, and investor's risk aversion. In practice, predicting future returns and variance is challenging, and defining risk aversion can be subjective, leading to potentially wide swings in optimal asset allocation.

Another recent working paper, using a million simulations based on historical data, found that when leverage is allowed at a realistic cost (1.4% above the risk-free rate), households optimally apply 2x leverage early in life, decreasing over time, while investing in a portfolio of approximately 34% domestic stocks and 66% international stocks.

Risks and Realities of Leveraged Investing

While the theoretical case for leverage can be compelling, it comes with significant risks, including high volatility and the potential for total loss of financial assets. A 2x leveraged S&P 500 ETF fell nearly 80% during the Great Financial Crisis, and a 3x leveraged S&P 500 ETF experienced a similar drop at the start of COVID-19. Such events can be psychologically devastating for investors. As journalist Jason Zweig noted, holding a leveraged fund long-term is suitable only for those who can endure extreme market fluctuations.

Beyond short-term downturns, there's also a risk of long-term underperformance. In markets like emerging markets, leveraged ETFs have sometimes underperformed the underlying assets due to volatility drag, fees, and financing costs. Even in the US market, a live 2x leveraged S&P 500 mutual fund underperformed a non-leveraged S&P 500 ETF for decades before recently pulling ahead, partly due to higher fees and financing costs in its earlier history.

Methods of Obtaining Leverage

Leverage can be obtained through various means, each with its own trade-offs:

• Margin loans: Borrowing from a broker.
• Lines of credit: Borrowing from a bank.
• Derivatives: Such as futures or options.
• Leveraged ETFs: These apply leverage to an underlying asset within an ETF wrapper, often using swaps and/or futures.

Leveraged ETFs offer convenience, simplicity, and non-recourse, meaning investors cannot lose more than their initial investment. They also provide access to institutional financing costs, though with higher fees.

Volatility Decay and Daily Resets

A common concern with leveraged ETFs is "volatility decay," the long-term effect of maintaining constant daily leverage. Leveraged ETFs aim to provide a multiple of the daily return of the underlying index. This requires daily rebalancing: if the index goes up, the fund buys more exposure to maintain its leverage ratio; if it goes down, it sells. This has been cited as a reason against daily leveraged ETFs for long-term investors.

However, the impact of volatility drag is insensitive to rebalancing frequency, assuming no serial correlation in returns. If there is positive serial correlation, more frequent rebalancing can be beneficial; if negative, it can be detrimental. The actual impact depends on the specific return outcomes, making it an empirical question.

Recent research has challenged the notion that daily resets inherently lead to value destruction:

• A 2026 working paper on single-stock leveraged ETFs found that daily resets did result in a cost over their benchmark due to the specific return paths of individual stocks.
• A 2022 paper comparing leveraged ETFs with daily resets to index funds on margin found that leveraged ETF returns were higher during strong bull and bear markets but lower during moderate markets. They also found leveraged ETFs offered reduced downside risk and were less risky than margin during every bear market since 1927.
• A 2025 working paper, funded by ProShares, concluded that daily leverage resets in leveraged ETFs are not the problem they have historically been made out to be, with long leveraged index ETFs aligning closely with portfolios without daily rebalancing for holding periods up to a quarter and reasonably well up to a year.

Costs of Leveraged ETFs

A 2026 working paper identified five determinants of leveraged ETF performance: volatility drag, fees, financing costs, product launches, and market timing. Volatility drag is a real phenomenon, amplified by leverage, and is distinct from rebalancing effects. The paper illustrates how volatility drag scales with volatility, showing that higher volatility drives a larger wedge between leveraged and underlying asset returns. For example, an underlying asset with 5% daily volatility would require a nearly 100% annual return for a 2x leveraged ETF to simply match the unlevered asset's performance, even before financing costs.

The paper found that leveraged index ETFs have generally been beneficial, but single-stock leveraged ETFs face higher borrowing costs, significant volatility drag, and poor timing by investors. Morningstar research indicates that single-stock leveraged ETF investors are more likely to lose over 75% of their investment than to outperform the underlying stock.

Expense ratios for equity index and single-stock ETFs are around 1%. However, financing costs, which are embedded in swap contracts and not reflected in the expense ratio, are also significant. For 2x leveraged index ETFs, financing spreads can be 0.5% above the risk-free rate, leading to total costs potentially exceeding 5% annually at current risk-free rates. For single-stock leveraged ETFs, market-cap-weighted financing spreads can be nearly 10 percentage points above the risk-free rate, pushing total costs close to 12%. These high costs significantly hinder the performance of single-stock leveraged ETFs.

Conclusion

Another 2026 working paper directly defends leveraged index funds for long-term investors, arguing that daily rebalancing produces convex payoffs that do not inherently underperform linear benchmarks and are not value-destroying. The authors suggest that the "demonization" of these funds has discouraged long-term investors from using them to achieve financial goals.

Leveraged ETFs are not an all-or-nothing proposition. Investors can combine them with regular index ETFs to achieve a desired overall leverage level. For example, a mix of 75% regular index funds and 25% 2x leveraged index funds results in 1.25x leverage. Newer products in Canada offer 1.25x leveraged equity index funds using cash leverage and rebalancing bands instead of daily resets.

In summary, leverage is a double-edged sword, amplifying returns and volatility, and incurring costs. While theoretically beneficial for some investors, particularly young individuals with high human capital, it demands a high tolerance for risk and volatility. The long-held belief that daily reset leveraged index ETFs are unsuitable for long-term investors is increasingly being challenged by research, which suggests that daily leverage resets do not cause volatility drag; volatility itself does. However, single-stock leveraged ETFs, with their higher costs and volatility, remain a much harder case to make for investors.