Why Leveraged ETFs Are Unsuitable for Long-Term Holding: The "Volatility Drag" Investors Must Understand

TradingKey - Leveraged Exchange-Traded Funds (Leveraged ETFs) attract significant attention for their unique return-amplification features, yet remain highly controversial due to widespread misuse.

Marketing phrases like "TQQQ triples profits" or "UCO doubles effortlessly" commonly mislead investors into treating leveraged ETFs as long-term wealth-building tools. However, at the structural core, leveraged ETFs fundamentally differ from traditional index ETFs—their design logic dictates they can only function as short-term tactical instruments.

(Source: Freepik)

Volatility drag is one of the core reasons leveraged ETF returns deviate from expected performance. It typically occurs when markets experience significant volatility without a clear directional trend.

Essentially, this is a mathematical effect caused by leveraged ETFs’ use of "daily compounding." During fluctuations, the compounding mechanism creates asymmetric returns for symmetrical price movements—meaning gains fail to fully offset equivalent losses. After repeated oscillations, capital may be continuously eroded without notice.

We can understand this phenomenon through an intuitive example:

Take the simplest case: Suppose the Nasdaq-100 Index rises 5% on Day 1, then falls 5% on Day 2. The index nearly returns to its starting point (1 × 1.05 × 0.95 = 0.9975, a mere 0.25% loss). But what results would an investor holding TQQQ face?

Over two days, the index barely loses value, yet TQQQ incurs a 2.25% loss.

To maintain target leverage ratios (e.g., 2x or 3x), these funds dynamically adjust their derivative positions daily based on that day’s net asset value changes. If the market rises on Day 1, total assets increase—managers must expand positions overnight. If the trend reverses on Day 2, declines occur on a larger capital base, triggering sharper losses and accelerating net asset value erosion.

In leveraged ETF operations, the daily reset mechanism creates path dependency, where long-term returns heavily rely on the sequence of price movements. This means that even if the underlying asset reaches the same final price, different sequences of gains and losses can produce vastly different compounded returns.

For instance, a path of three consecutive 6.7% daily gains (moving from 100 to 121) yields far superior results than a path involving sharp rallies followed by steep declines that net the same endpoint.

Under certain "idealized" conditions—such as multiple consecutive days of positive returns (a clearly defined uptrend)—leveraged ETFs can leverage daily compounding to generate cumulative short-term gains exceeding their nominal leverage ratio (e.g., over 3x). Unfortunately, such trends typically lack sustainability in real markets. Consequently, many profitable outcomes remain confined to theoretical space or brief cyclical windows.

Beyond volatility risks, management fees represent another significant cost source impacting leveraged ETFs’ long-term performance. Compared to traditional index ETFs, these products typically charge substantially higher fees—not only due to strategy complexity but also because they encompass greater derivative trading costs. These fees are dynamically deducted daily from the fund’s net asset value, making them difficult for investors to directly perceive in daily holdings, yet they persistently erode net performance.

Take TQQQ—a well-known 3x leveraged long ETF tracking the Nasdaq-100 Index—as an example. Its current annual expense ratio stands at 0.82%, while its unleveraged counterpart, the Nasdaq-100 representative ETF QQQ, charges only about 0.20%.

This seemingly minor 0.62 percentage point gap may appear negligible in the short term. However, when extended over investment horizons of five or ten years, this difference transforms into a profoundly impactful factor.

More critically, certain commodity-based leveraged ETFs incur additional structural costs. Products like UCO (2x leveraged long WTI crude oil), for instance, track not spot prices but near-month crude oil futures contracts. To maintain continuous exposure, such funds must regularly execute "roll operations"—selling expiring contracts while simultaneously buying new contracts for the next cycle.

If the market is in contango (where futures prices for later months exceed near-term prices), the fund perpetually sells low and buys high, effectively incurring a price differential loss with each roll.

This recurring loss from roll operations is termed roll cost. It is not a single-day catastrophic event but a slow, imperceptible erosion of profits—like constantly buying new apples at premium prices while selling old apples at discounts. Though seemingly just a rotation, the price gap gradually gnaws away at returns.

This invisible but real term structure drag becomes a major driver of net value decline, especially during sideways commodity price phases—such as when Brent/WTI crude volatility narrows. Consequently, even with correct directional bets, investors may see actual profits severely compressed or even reversed due to these hidden expenses.

Within normal volatility ranges, leveraged ETFs already experience "gentle erosion" from path dependency and volatility drag. However, during severe one-way downturns, their net values exhibit a far more direct and violent accelerated loss effect.

For example, during the 2022 U.S. equity market correction, the Nasdaq-100 Index fell approximately 33% for the year. Yet its 3x leveraged long instrument, TQQQ, plummeted nearly 71%. This was not linear amplification but a geometric compression of capital—far exceeding what a simple 3x multiplier would suggest.

Because TQQQ tracks 3x the index’s daily returns, the cumulative decline requires the underlying index to rebound by a magnitude far beyond theoretical expectations just to recover to its original price.

(Source: Freepik)

1. Control Holding Periods

Leveraged ETFs undergo daily compounding rebalancing based on their tracked index. The longer the holding period, the greater the risk of deviating from the underlying asset’s performance. General guidelines:

• 3x leverage products (e.g., TQQQ): Suitable for ultra-short holding periods—hours to a maximum of 3 days.
• 2x leverage products (e.g., UCO): May extend slightly to several days or up to 2–3 weeks.

Critical rule: Avoid holding any leveraged ETF for over one month. These instruments should only be deployed during clear, strong unidirectional trends. Exit decisively once markets enter sideways/choppy phases.

2. Reduce Position Sizing

Even seasoned professional traders adopt extremely conservative position sizing for single leveraged ETFs:

Allocate no more than 1%–3% of total assets to any single leveraged ETF.

Example: For a $100,000 portfolio, limit exposure to high-volatility products like TQQQ to ≤$3,000.

This ensures that even a severe 30% drawdown impacts the overall portfolio by less than 1%, effectively isolating risk and preventing single-trade errors from triggering systemic damage.

3. Align with Market Trends

Leveraged ETFs excel most at "riding the wind of trends," but are unsuited for bull-bear tug-of-war periods or times of ambiguous direction. Therefore, one must "choose the right timing," entering positions only when trends are clear—for instance, using TQQQ when the Nasdaq Index breaks through key technical resistance levels and multiple indicator resonance signals confirm an upward trend;

Sideways markets often amplify intraday volatility and the ETF’s internal "decay effect," causing the fund’s net value to continuously erode even if the index itself doesn’t decline.