Leveraged index funds generally work as expected on an intraday basis - but they're not intended for longer term holds. You can of course try it, but things will not turn out as you'd hope. Here's an article describing what happens:

https://www.investopedia.com/articles/financial-advisors/082...

Outside of tracking error and expense fees, there is a more fundamental issue. When the market goes down X%, you need it to go back up Y = 1/(1-x)-1 to break even. So the market goes down 10.0% one day and then up 11.1% the next, an investor in the normal 1x is back to where they started. A 2x investor is still down and a 3x investor is down even more. So the average daily noise of the market kills you.

> So the market goes down 10.0% one day and then up 11.1% the next, an investor in the normal 1x is back to where they started. A 2x investor is still down and a 3x investor is down even more.

Can you explain why that is? I would have expected that your gain or loss from the leverage funds relates only to the difference in price between when you purchased and when you sold (multiplied by the leverage).

Because of the triple leverage, a 33.33% drop would entirely wipe out the fund. Back to $0. A 33% drop in a single day has never happened (1987 Black Monday was 22%) but it definitely does happen if you consider a longer time frame.

Hence why it's reset daily, as the other two responses explain.

And in case it's not been made clear enough: it's the very opposite of a sound investment. It's very much a risk management / trading instrument. It's something you would trade as a hedge or leg of a complex trade; not something you want to hold by itself.

The leveraged funds like TQQQ reset their leverage on a daily basis.

the leverage amounts typically "reset" daily (not always; read the prospectus) so if you lose 10% (say $100 => $80) at 2x your day 2 base is $80; a 10% gain that day would average out to 0 on net but you would gain 20% of $80 => $96

I read that 3x leverage is bad because of volatility drag or something like that so 2x "is the sweet spot"

SSO is 2x leveraged SP500

https://finance.yahoo.com/quote/SSO

Check out the chart since 2007 versus the SP500 index to today. I'm seeing 211% return for SSO, 113% for SPY.

Just remember that we've pretty much been in a full on bear market ever since the last recession. Whether or not terrible things would have happened to SSO if we experienced a true recession/crash and whether or not you would actually recover/beat SPY, I have no clue and am not qualified to say.

But, based on the cherry picked '07-'19, yes, SSO (2x SPY) beats SPY (1x SP500) 211% to 113%

It really depends, see my blog post on the matter (part 1):

https://smabie.github.io/posts/2019/10/04/vol.html

In short, assuming a normal distribution, your max leverage ratio should be the future expected returns divided by the expected variance.

I’m not at a computer right now so I can’t run the math on real S&P returns, but assuming 10% returns and 10% vol and a normal distribution, the highest leverage ratio you would ever be able to justify is 10/10^2 or 10x leverage.

In my blog post I looked at the beginning of 2018 up to present. The ideal leverage ratio according to my equation (I’m sure it’s not novel, but haven’t been able to find anyone else talking about it), is 2.99x.

Of course, the more skew or kurtosis the distribution has the less accurate this equation becomes.

Right now I’m working on a hypothetical S&P ETF that adjusts leverage bases on forecasted volatility and returns. Almost impossible to get right, but my preliminary model has outperformed (not risk adjusted) any fixed leverage I’ve thrown at it.

You made a blog post that 10x leverage would be good given the past 12 months (where the market has mainly been up-up-up)? Doesn't that 100% ignore the effects of drag when the market goes down-down-down?

First of all, the market has not been exactly “up-up-up.” There has been massive volatility and drawdowns in the last year.

Second, my analysis was from the beginning of 2018 to present. Using that data, the ideal leverage ratio is 2.99x.

Third, the ret/var model put forth in the post assumes a log-normal distribution. The less log-normal the returns are, the less accurate it becomes. Excess kurtosis or skew will definitely affect the accuracy of the model. So the model would probably be fine if the market was up-up-up or down-down-down, I haven’t encountered any periods in which the non-normality of the distribution is so severe that it completely breaks the model.

You also need to pay interest on the leveraged margin, so on the long term you'll lose more money on interest than you'll gain.

This isn’t true. Market returns are almost always going to be higher than the borrowing cost. In fact, I can’t think of a single hedge fund that doesn’t use leverage either through: shorting, borrowing, options, or futures.

Leverage is almost always the secret sauce to institutional strategies. And if we’re talking about quant funds, without leverage they wouldn’t exist.

"Market returns are almost always going to be higher than the borrowing cost"

This sounds like perpetual motion to me. It's like Moore's law - no matter how long it's gone on for, it can't go on forever.

If everybody believes that, and people who actually control trillions of dollars do it on a massive enough scale, just borrow money and invest in stock, then it has to break things down at some point, doesn't it?

Due to volatility tax [1], there’s an upper limit on how much leverage you can assume. This amount is a function of forecasted returns and variance: r/var(r). The larger this ratio is, the more leverage you can take on. In general, just investing in the broad equity market with anything above 3-5x leverage over the long-term is probably unadvisable. So groups like hedge funds first reduce their volatility by going long and short, and then leveraging up afterwards. Even with market neutral funds (0 market exposure), the leverage applied rarely goes past 6x nowadays.

Banks are a little different and while the rules are complicated, big banks need to have around 3% of their total book at hand. Or in otherwords, they have around 33x leverage. Because of the leverage, banks need a very diversified uncorrelated portfolio in order to reduce volatility. No bank would stuff all of their money into equities, the risk of ruin is too high.

Also, there’s another perspective to look at your question: the efficient market hypothesis. In short, EMH states that in general, all investments have the same or trend toward the same risk/reward profile. That is, the ratio or slope of the returns vs volatility should be the same. With debt/credit, there are two primary options: you get paid back with interest or you don’t (let’s ignore bankruptcy). With equities you are assuming a lot more risk, the stock could go up or down or whatever. Since you are assuming more risk with equities than credit, it would violate EMH if you weren’t compensated for the extra risk.

This however, doesn’t explain why equities perform so much better than everything else. This is called the equity premium puzzle [2].

So maybe you’re right? No one really knows. Maybe the jig will eventually be up? Or maybe not, no one really knows.

[1] https://en.m.wikipedia.org/wiki/Volatility_tax

[2] https://en.m.wikipedia.org/wiki/Equity_premium_puzzle

I spent some time thinking about leverage and margin, and my thinking was

- I don't want to invest on margin unless the interest rate is significantly lower than stocks generally return

- as a rule of thumb, 7% is a conservative estimate for stocks in the long run, while a typical broker charges close to 10%. So it seemed like a non starter.

- however, it is possible to find rates as low as 3-4%, so then the question becomes how much leverage to use?

- my logic was, what kind of drawdown is plausible if you invest at a market peak? It appears based on known history that -70% could happen. Therefore it would be best to limit leverage so that more than a 70% decline would be needed to cause a margin call.

- which seems to lead to borrowing no more than 25-27% of one's equity.

for a large number of reasons it's hella hard to make money in finance. you can make whatever the vanguard index fund makes "for free" in your pajamas, so in order to justify your existence as an org within a financial institution you're going to need to put together some returns that are, obviously, way higher than that. so out come things like leverage and derivatives (=> hyper-leverage).

and yeah, there are failures, and they lose their shirts, and the beat goes on. but you're probably not going to make very much money (=> last very long) if your rate of return is the same order of magnitude as the collateral you're taking out. it's just not worth it from the POV of the bank.

But isn't much of their money being made from fees?

Clearly not, gains of the stock market are much higher than interest