Leveraged Funds Pose Hidden Risks Many Investors Overlook

Leveraged funds, which allow investors to gain multiplied exposure to assets, indices, sectors, and stocks, have become increasingly popular amid recent market rallies. These funds typically offer two to three times the exposure of the underlying asset, aiming to amplify gains. However, beyond the obvious risk of losses when the asset moves against the investor, there is a less recognized danger known as "decay" or "wearing down" over time, which can erode returns even if the underlying asset fluctuates around the same levels.

For example, if an investor buys a stock at 1,000 shekels and simultaneously invests in a triple-leveraged fund tracking that stock, a 10% rise in the stock price will yield a 30% gain in the leveraged fund. But if the stock then falls by 10%, the leveraged fund’s value drops disproportionately, resulting in a net loss despite the stock returning close to its original price. This effect, caused by the way percentage gains and losses compound, can significantly reduce the value of leveraged funds over time.

A real-world illustration involves semiconductor sector funds: SOXL, a triple-leveraged fund tracking the SOXX semiconductor ETF, and SOXS, which offers triple-leveraged inverse exposure (short position) to SOXX. Over the past three months, all three funds declined, SOXX by 25%, SOXL by 47%, and SOXS by nearly 10%, despite SOXS theoretically benefiting from SOXX’s drop. Over five years, SOXX rose 240%, SOXL 154%, while SOXS barely moved, highlighting the risks of leveraged and inverse leveraged funds, especially in volatile sectors.

Investors should be aware that leveraged funds often carry higher management fees and that their performance can deviate significantly from expectations due to volatility decay. While these funds can amplify profits in trending markets, they also magnify losses and can erode capital over time, making them suitable primarily for short-term trading rather than long-term holding.