The Truth About Leveraged ETFs | #430

Episode Summary

Executive Summary: The episode opens with a correction to the prior marriage-finances discussion by adding Kelly Thomas to highlight blind spots around household spending roles, career sacrifices, and financial autonomy. The main segment revisits leveraged ETFs, arguing that daily reset mechanics are not inherently “bad”; instead, leverage itself raises volatility and costs, while outcomes depend on return paths, financing rates, and investor behavior.

Main Topics: Adding a female advisor perspective to marriage and money (Priority: 5/5): Kelly Thomas critiques the prior episode’s framing by emphasizing household mental load, career sacrifices, financial autonomy, and the difference between secrecy and healthy transparency in joint finances. Spendthrift vs. tightwad is not just personality (Priority: 4/5): The conversation reframes spending habits as partly a function of household roles and who manages family expenses, rather than a simple behavioral type. Career sacrifice and prenup considerations (Priority: 4/5): They discuss how parental leave, reduced hours, and missed promotions create financial inequality during marriage that standard prenups often do not fully capture. Human capital and the theoretical case for leverage (Priority: 5/5): The hosts review lifecycle theory suggesting young investors with bond-like human capital and low financial wealth may optimally use leverage to increase equity exposure. Why leveraged ETFs were misunderstood (Priority: 5/5): Ben revisits his prior view that daily reset leveraged ETFs suffer from decay, then explains newer research showing daily resets are not the cause of underperformance; volatility and financing costs are the real drivers. Empirical evidence on leveraged ETFs and single-stock products (Priority: 5/5): The episode compares index leveraged ETFs and single-stock leveraged ETFs, showing that diversified index products have been more defensible while single-stock versions face much higher costs and worse investor outcomes.

Key Arguments: Household spending labels like “spendthrift” and “tightwad” can be misleading because one partner may simply be responsible for more family spending and mental load. Financial planning should account not just for wealth brought into marriage, but for wealth and earning capacity lost during the marriage through caregiving and career interruptions. Transparency in marriage should mean access to assets, credit, and the full financial picture—not micromanagement of every purchase. The classic leverage argument rests on an assumption that human capital is safe and bond-like, but in reality wages often fall when markets fall, weakening the case for borrowing to invest. Behaviorally, leverage is hard to sustain because young investors often lack experience with deep drawdowns and may not know their true risk tolerance. The commonly cited “daily reset decay” explanation is incomplete; the main sources of drag are volatility, leverage costs, financing costs, and the realized sequence of returns. Daily resets can sometimes reduce downside risk versus static leverage in severe bear markets, so they are not automatically harmful. Leveraged ETFs can be appropriate for some investors, but they are generally easier to justify for broad indexes than for single stocks. Single-stock leveraged ETFs are especially problematic because they combine high volatility, high financing costs, and poor investor timing. The right question is not whether leverage can maximize returns, but whether higher returns are actually needed to meet the investor’s goals.

Data Points: Episode number: 430 - Current Rational Reminder episode discussed in the transcript. Webinar date: November 4th at 12:15 p.m. Eastern Time - Private webinar celebrating the launch of David Booth’s book, Stay Calm. Free-book offer: First 250 Canadian residents - Registrants for the webinar receive a free copy of Stay Calm. Hypothetical leveraged ETF outcome: $10,000 invested in ProShares UltraPro S&P 500 3x ETF launched in 2009 would be worth $1.3 million today - Used to illustrate how powerful leverage can be during a long bull market with low volatility and low financing costs. Relative performance vs regular S&P 500 ETF: More than 10x the dollar amount of a regular S&P 500 ETF - Comparison of the 3x ETF’s hypothetical ending value to an unlevered benchmark. Leverage ratio example: 2x - A leveraged ETF giving exposure to twice the daily return of the underlying index. Bear-market drawdown: A 2x leveraged S&P 500 ETF fell nearly 80% in the Great Financial Crisis - Illustrates how leverage magnifies drawdowns. COVID drawdown: A 3x leveraged S&P 500 ETF fell nearly 80% at the beginning of COVID - Shows severity of short-term losses in leveraged products. Sample historical period: 2009 to present (about 17 years) - The period that made the 3x ETF example look unusually strong due to high returns and low volatility. Index leverage cost: About 0.5% above the risk-free rate - Estimated financing spread for 2x leveraged index ETFs in the cited research. Total annual cost: Could exceed 5% per year - Estimated combined funding spread, risk-free rate, and fees for a 2x leveraged ETF at current rates. Single-stock ETF total cost: Around 12% - Morningstar-referenced estimate driven by much higher financing spreads for single-stock leveraged ETFs. Single-stock financing spread: Nearly 10 percentage points above the risk-free rate - Explains why single-stock leveraged ETFs are much more expensive than diversified index versions. Single-stock ETF underperformance/outperformance: 19% lost over 75% since inception; only 18% outperformed the underlying stock at all - Morningstar data on single-stock leveraged ETFs.

Pivotal Quotes: "“Daily leverage resets do not cause volatility drag. Volatility causes volatility drag.”" — Benjamin Felix: Core clarification of the main misconception about leveraged ETFs. "“If you have the money available to leave, but you choose to stay, that's when you know that you're in a healthy relationship.”" — Therapist friend quoted by Benjamin Felix: Used to illustrate why access to funds matters in discussions of financial autonomy and abuse. "“I don't think that because it can be used irresponsibly is a reason that nobody should use it at all.”" — Dan Bordolotti: Discussion of leverage as a tool that can be used sensibly in some contexts.

Implications: Listeners should separate leverage from daily-reset mechanics: leverage raises risk and costs, but daily resets are not the core problem. Broad index leveraged ETFs may suit a small subset of disciplined investors; single-stock leveraged ETFs look far harder to justify.