As legendary investor Warren Buffett has said on more than one occasion, "If you're smart, you don't need leverage."
So Buffett isn't a fan of leverage. Easy for him to say, right? His net worth is more than $100 billion. What about those of us who don't have a few billion dollars of cash in the bank? What's the harm with a little leverage?
Well, it's time to examine some leveraged single-name exchange-traded funds (ETFs) to see how they work and whether they're appropriate for the average investor. Let's get started.
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What are leveraged ETFs anyway?
Let's start at square one: Leveraged exchange-traded funds are investment products that use derivative products (stock options) to create returns that amplify the price movements of some underlying security.
So, a leveraged ETF might, for example, seek to provide twice the daily return in a stock market index like the S&P 500.
However, in the case of the GraniteShares ETFs, the funds seek to amplify the daily returns of a single stock. The company offers funds for several high-profile stocks, including Apple, AMD, Amazon, Alibaba, Coinbase Global, Meta Platforms, Nvidia, and Tesla.
Some of the company's funds are long; some are short. The long funds seek to double the daily positive return of a given stock. So, for example, the company's GraniteShares 2x Long NVDA Daily ETF (NASDAQ:NVD) aims to double the percentage return of Nvidia stock -- if Nvidia's stock rises 2% one day, the fund aims to generate a 4% return on the same day.
The short funds work the same way, but inverted. For example, the GraniteShares 2x Short NVDA Daily ETF seeks to double the negative daily return of Nvidia's shares. In this case, if Nvidia's stock fell 2%, the fund should generate a positive return of 4%. Similarly, a 2% rally in Nvidia shares should generate a 4% loss for the ETF.
Why leveraged ETFs are not for the long-term investor
Now, at first blush, leveraged ETFs might seem like a great idea for the long-term investor. After all, if someone is bullish on, say Nvidia, why not be twice as bullish?
However, like many things in life, it's more complicated than that.
Leveraged ETFs are not designed for long-term investing -- and you don't have to take my word for it. Here's the investment objective of the GraniteShares 2x Short NVDA Daily ETF from the GraniteShares website:
"The Fund seeks daily investment results, before fees and expenses, of -2 times (-200%) the daily percentage change of the common stock of NVIDIA Corp
There is no guarantee that the Fund will meet its stated objective.
The fund should not be expected to provide -2 times the cumulative return of NVDA for periods greater than a day."
Right off the bat, two things should be clear:
- The fund does not guarantee its performance will match its stated goal.
- The fund is not designed to generate leveraged returns for any period longer than a day.
Both of those caveats matter enormously for the long-term investor. First, an upfront acknowledgement that a fund may not meet its stated objective should give investors pause. Second, by noting that the fund should not be expected to provide levered returns for more than a day, the fund managers are revealing who this type of product is for -- short-term traders.
On top of that, the fund charges an enormous fee. The expense ratio for the GraniteShares 2x Short NVDA Daily ETF is an eye-popping 1.74%. That means an investor who puts $10,000 in the fund will pay $174 in annual fees. For context, the Vanguard S&P 500 ETF -- one of my favorite ETFs -- has an expense ratio of only 0.03%, meaning an investor pays only $3 a year in fees for every $10,000 investment.
In summary, maybe Buffett was on to something after all. Leverage often comes with strings attached. For the vast majority of investors, it's best to just keep things simple. A standard index fund that charges a low expense ratio is a much better alternative to a leveraged single-stock ETF.
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Randi Zuckerberg, a former director of market development and spokeswoman for Facebook and sister to Meta Platforms CEO Mark Zuckerberg, is a member of The Motley Fool's board of directors. John Mackey, former CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool’s board of directors. Jake Lerch has positions in Amazon, Nvidia, and Tesla. The Motley Fool has positions in and recommends Advanced Micro Devices, Amazon, Apple, Coinbase Global, Meta Platforms, Nvidia, Tesla, and Vanguard S&P 500 ETF. The Motley Fool recommends Alibaba Group. The Motley Fool has a disclosure policy.
