Swordfish: There’s So Much Leverage
Markets are set for a banner year. Wall Street analysts see further gains for stocks in 2025, with one estimate putting the S&P 500 at 7,100. That price target implies a 17% rally in 2025.
Naturally, with markets strongly rallying, investors are looking to catch up. And one way to do that is with the use of leveraged ETFs. These funds are designed to capture double the market’s move. Today, there are now triple and even a few quadruple ETFs.
This amount of leverage could be great for investors, provided their timing is perfect. However, this kind of leverage involves holding futures and other derivative contracts.
So over time, those contracts will lose their time premium. And investors on the wrong side of the trade will be worse off. This “tracking error,” as it’s known, has long been a feature of leveraged ETFs.
Today’ rise of 3X and 4X leveraged funds have a more significant tracking error than the 2X ETFs. In a bull market, the investor with the most leverage tends to win.
However, the trend can’t last forever. The rise of retail investors into leveraged funds could be a sign of a market close to topping out. That’s because investors are now looking to chase markets after they’ve been rallying strongly for two years.
For now, investors should look to avoid leveraged ETFs. Buying into them after a bear market could be a stronger strategy.