Leveraged and inverse funds are popular with active traders, but they are coming under increased regulatory scrutiny. These funds are designed to achieve a multiple of an index’s return on a daily basis. For example, a double-leveraged fund should move twice as fast as the index it tracks.

It is debatable whether these funds work as advertised. In my book, Exchange Trade Profits, I used the example how China ETFs handled the 2008 financial crisis. Chinese ETFs lost half their value from mid-March through mid-November. In that environment, surely the ProShares Ultra-Short China (FXP) was a very good security to own. Not so fast. During that period FXP lost 25% of its value.

A more recent example is seen in March/April 2020. The Nasdaq 100 ETF (QQQ) plunged 7.5% in March only to recover in April, gaining 6.4% over the two month period. Over the same period ProShares UltraPro QQQ (TQQQ), which uses triple leverage, lost 9.5% and ProShares UltraPro Short QQQ (SQQQ), which is designed to move inversely to the Nasdaq 100 index, lost 50%.

What’s going on? Leveraged and inverse ETFs are designed to match the daily return of their benchmark indexes. The fund typically holds stocks, index futures, swaps, or short positions along with cash equivalents to achieve this daily fund objective on an ongoing basis. So on a given day, if the index is down 1.5%, then the double-leveraged inverse ETF should be up about 3%.

Over longer periods, however, the returns won’t match due to compounding. Adding and subtracting the daily percentage returns over a month doesn’t equal the percentage change for that month. Tracking results worsen in periods of high volatility, as we saw in March/April 2000.

Compounding doesn’t always hurt a fund’s performance. Suppose a double-leveraged fund rises 10% three days in a row. Its return would be 33.1%. Assuming the index rose 5% on each of those days, the leveraged three-day return was more than double the 15.8% return on the index. Strong uptrending markets are a leveraged fund’s friend.

This year is a good example of a strong uptrending market with very little volatility. That’s when leveraged funds work. Through last week, the S&P 500 is up 25%. The Direxion Daily S&P 500 Bull 3X (SPXL), which should move three times the S&P 500, is up 91%.

Bottom line: Leveraged and inverse ETFs work well for day-traders, but because of compounding and tracking error these ETFs work poorly when the market turns volatile. They are not good buy-and-hold investments.

David Vomund is an Incline Village-based Independent Investment Adviser. Information is found at http://www.VomundInvestments.com or by calling 775-832-8555. Clients hold the positions mentioned in this article. Past performance does not guarantee future results. Consult your financial advisor before purchasing any security.