Young & Invested: Why these ETFs might require caution
Investigating a high risk, high reward approach to ETF investing.
Welcome to my column, Young & Invested, where I discuss personal finance and investing for Gen Z and Millennials.
This column aims to be a resource for young investors navigating an ever changing financial, political and social landscape as they try to build wealth. Tune in every Thursday for the latest edition.
Edition 39
If you could double, triple, or even quadruple your returns to reach your financial goals faster, you would, right? Now what if I told you that trying might come at the cost of consistency or even the capital itself? Let me introduce the world of leveraged investments.
In its simplest form, gearing or leveraging is the process of using your own capital and additional borrowed funds to purchase an investable asset. This is done to increase exposure and potentially amplify returns.
Most Aussies will tap into gearing at some point in their life (likely in the property market) but this can be applied across all sorts of asset classes.
The ASX has hosted leveraged products for years, but the ETF wrapper has introduced a new wave of accessibility. I’ve noticed a few geared products pop up recently which makes now a great time to unpack what they offer and what they demand from investors.
What is a geared ETF and why do they exist?
A geared or leveraged ETF uses borrowed money to increase your exposure to the market. A key metric to note is the ‘gearing ratio’, which refers to how much of the fund’s total exposure is funded by debt. A gearing ratio of 50% implies half of the funds market exposure comes from borrowing.
Say I invest $1,000 into a fund with 50% gearing. The fund borrows another $1,000 on my behalf, giving me $2,000 of market exposure. That’s called 2x gross or market exposure. In simple terms it means I get $2 of exposure for every $1 that I invest.
Geared ETFs exist to give investors a way to amplify returns without having to use margin loans or derivatives themselves. It’s a simple notion but the mechanics may vary in practice.
The US has recently seen a rise in leveraged product launches. When a new or niche strategy is suddenly accessible, it’s easy to mistake it as a contender for your portfolio. But not every product is suitable for every investor. Whilst the floodgates haven’t quite opened in Australia, it’s worth considering the implications.
Source: Barrons. 2025.
The role of volatility
When markets get choppy, financial institutions tend to split into two camps. One half floods the airwaves with tactical plays and new takes, whilst the other half (us included) spend time urging investors to stay focused on the long-term.
If markets generally rise over time, many look at geared funds and wonder why every investor doesn’t try multiplying market returns with leverage. Unfortunately, the logic doesn’t quite hold up as neatly in practice. These funds aren’t just market multipliers. They’re a bet on several moving parts like benchmark returns, market volatility and the cost of borrowing.
Volatility in particular plays a major role. Even in rising markets, leveraged ETFs can erode returns by magnifying both gains and losses. This is referred to as volatility decay. Investor expectations of amplified performance generally don’t materialise as well as they’d hope.
The kicker is that negative returns have larger impact than positive ones on a per unit basis, especially when leverage is involved.
Say you use a 2x geared ETF and the market drops 10%. Your investment falls by 20%, turning $100 into $80. To get back to the $100, you need a 25% gain – not just the original 20%.
In contrast, the non-leveraged investment that drops 10% to $90 only needs a 11.1% gain to reset to recover. In this case, the recovery burden is effectively quadrupled. Every loss demands a bigger recovery and leverage makes that recovery harder.
If the benchmark is volatile, the fund may rebalance more frequently to stay within gearing limits. This can reduce exposure during market recoveries and hinder compounding. Many sophisticated investors view geared funds as short-term instruments given the effect of volatility decay. To use them over the long-term could result in outcomes investors don’t expect. This is especially relevant when markets are turbulent.
In theory, if an index ends the week higher, a leveraged fund should easily outperform. But in practice, the path of returns matters more. These funds tend to perform worse than their headline gearing level would imply.
In a previous article, Mark simulated a scenario of geared and non-geared fund performance through a short period of heightened volatility. The chart below shows a 10-day period where the index alternates between 2% losses and 3% gains.
Source: The promise and peril of geared ETFs. Mark LaMonica. 2024.
In this scenario, returns for the geared funds outperformed the index. However, during longer or heightened periods of volatility, they can underperform not just the leverage multiple, but also the index itself (even if it is rising).
The counter argument
Volatility drag is a cost that all portfolios face, with more volatile portfolios having lower balances than less volatile portfolios, even if returns are the same.
Volatility decay is caused by compounding leveraged returns over time. The mechanics of volatility decay is why many long term buy and hold investors consider geared funds unsuitable. But is this actually true?
I spent the better part of my Sunday evening reliving my uni days by reading through Alpha generation and risk smoothing using managed volatility (2010) by Tony Cooper. The paper is well-cited among those who challenge the conventional wisdom on the long-term prospects of leveraged products.
I’m not one to play devil’s advocate for the sake of it, but investing is a nuanced field with multiple perspectives worth exploring. Cooper’s work is one of those.
Traditionally, leverage has meant borrowing money to invest. Either you’re leveraged or you’re not. The author reframes leverage is as a ratio of how much market exposure you have relative to your capital. By this logic, if I have $1 and invest the whole thing, my leverage ratio is 1x, even though I’m not leveraged by any conventional definition. Many assume traditional investing has zero leverage, but the author ascribes this a leverage of 1x.
The paper proposes a model where returns are a function of volatility, making outcomes more predictable. Cooper argues that the right strategy can capture the upside of leverage whilst smoothing out the downside.
Notably, he challenges the idea that volatility decay automatically disqualifies leveraged ETFs for long-term use. If even non-leveraged funds (1x) suffer from volatility, why do we consider them safe for buy-and-hold strategies? If 1x is fine, why not 1.01x or 1.1x? Where do we draw the arbitrary line in the sand?
Cooper establishes there is nothing inherently special about a 1x multiple and thus no reason that it strikes the optimal balance between volatility decay and capturing market returns.
He also looked at several global markets and found that historically optimal leverage hovered around 2x (excluding dividends). Naturally, the data is backward-looking but still makes an intriguing point.
Source: Returns vs leverage for a range of markets and time periods. Tony Cooper. 2010.
The author concludes that leveraged funds can be held long term if the market delivers enough return to overcome volatility decay - something which he believes has usually happened. Although, he does note that leverage doesn’t improve risk-adjusted returns since you’re magnifying both returns and volatility. I won’t unpack the full paper to keep things digestible, but if you’re curious it’s worth a deeper read.
The rebalancing dilemma
Geared funds often fall short of investor expectations. While volatility decay is frequently blamed, the discussion warrants additional nuance in a domestic context.
When markets move, a fund’s leverage drifts from its target. This requires the manager to rebalance and reset the intended gearing level. US geared funds perform this task daily while domestic funds operate within a band and only rebalance when it falls outside of a set range. This is said to be done to limit the unnecessary turnover associated with a daily resetting strategy.
Assume an Australian fund has target gearing of 20 – 30%. Say you purchase a $10 investment and the gearing is around 25%. This means that $2.50 is borrowed. If the fund rises 10%, its net asset value (NAV) becomes $11 and gearing drops to 23%. Since this is still within the band, no rebalancing occurs.
Rebalancing frequency matters in volatile markets, as daily schedules force funds to buy after gains and sell after losses to maintain leverage.
Compare $100 in a standard fund versus $100 in a 2x geared fund. If the index rises 5% on day one and falls 5% on day two, it ends down at -0.25%, while the geared fund loses 1% - that’s 4x the loss of the standard fund.
Author visualisation.
On day one, the geared fund gains 10% so its NAV goes from $100 to $110. To maintain its daily 2x leverage, the fund increases its market exposure to $220. Then on day two when the index drops 5%, the fund (now exposed to $220) loses 10%, reducing its NAV to $99.
Daily rebalancing to maintain constant leverage causes the fund to increase exposure after gains, which amplifies losses if the market reverses. Rebalancing isn’t the cause of volatility decay, but it’s the mechanism that enforces constant leverage (in some funds) that enables the compounding effect.
Cost transparency
Another caveat with geared funds is that their total costs go beyond the headline management fee we’re used to seeing with ETFs.
Because they take a more active approach, management costs are generally higher than more vanilla options and borrowing costs add another layer. This fee drag is another reason many argue geared funds aren’t ideal for the long term.
Take a hypothetical fee structure: You invest $10 into a fund geared at 50%, meaning the fund borrows another $10, giving you $20 of market exposure. If the fund charges a 1% management fee, it’s applied to the full $20, even though you only invested $10. Since you’re paying a fee on the gross asset value, it takes your effective fee to 2%.
Additionally, leveraged funds also incur borrowing costs, often separate to the headline fee. The kicker is that investors aren’t privy to the exact rate. Given the loans are sourced from the wholesale market, many estimate it’s around the RBA cash rate plus 1 – 2%. In today’s environment, this translates to around 5%.
When the benchmark index returns less than its borrowing rate, the ETF will underperform even if the index is up. I’m not here to speculate on how frequently this occurs in practice, however in high-rate environments it presents a much larger hurdle.
So why bother?
Leveraged ETFs are still considered a relatively cheap form of gearing compared to margin loans or home equity borrowing. The key question is whether the fund’s return will exceed its internal borrowing costs. In other words, you’re not just betting on market performance, you also need to cover debt costs to breakeven.
We can estimate the total costs using this formula:
Apply a fund with 50% gearing, a 1% management fee and 4% interest costs. If the benchmark rises 10% over the year, the geared return is 14% even though you might expect a 50% geared fund to deliver 20%. This illustrates the impact of additional fees.
Conversely, if the benchmark is flat (price decline fully offsets dividends and franking), the geared return would be -6%, purely due to costs.
Most discourse on geared funds emphasises volatility decay as the primary driver of performance drag over extended holding periods. While certainly relevant, borrowing costs may be the more critical implication for long-term holders, especially in high-rate environments.
Concluding thoughts
As young investors, we’re often encouraged to take risks and investing invites many interpretations of what that implies. Academically it’s standard deviation, Sharpe or Sortino ratios. In practice it’s simpler. The real risk to investing is suffering permanent capital loss or not earning a high enough return to meet your goals.
Geared funds promise to multiply returns which is understandably alluring. However, they also introduce a complex set of trade-offs that aren’t just mathematical but also behavioural. So despite the effect of volatility decay, opaque costs and shifting market conditions, my real concern is the poor behaviour these products might induce.
I think highly leveraged ETFs may flirt with the fine line between investing and gambling. As someone who used to treat the stock market like a pokies machine, I see how easily young investors chase high reward without fully grasping the risk.
There’s no shortage of debate online and the academic literature often contradicts itself. Still the probability of ruin is almost zero in a vanilla index fund. When we throw leverage into the mix that probability becomes finite. The stock market is already risky beyond what a lot of us can realistically tolerate. Adding leverage amplifies that volatility and with it introduces heightened emotional labour.
For me, there are simply too many moving parts to justify using these over the long-term. From the question of future optimal leverage, market volatility, sequencing risk, interest rate fluctuations and extreme behavioural discipline to stomach the losses. It’s not something I’m rushing to include in my portfolio, especially as global and domestic markets continue to look stretched. Although not inherently bad products, I’m sceptical about their suitability for most regular investors.
