Why Is My ETF Still in the Red Even Though the Index Has Recovered?... The Illusion of "Leverage" [Practical Finance]

Growing Interest in Leveraged ETFs as Investors Seek Rebound After Sharp Decline

Tracks Daily Returns, Not Cumulative Performance

"Negative Compounding Effect" Makes High Volatility Riskier

One of the first strategies that retail investors consider after a sharp stock market drop is "averaging down." The idea is to generate greater profits when the stock price rebounds after a decline. This approach has attracted even more attention from investors looking for a rebound, especially as a variety of "leverage" products, from index-based to single-stock, have been introduced to the Korean stock market.

Photo by Getty Images Bank

Leveraged Exchange-Traded Funds (ETFs) are designed to track approximately twice the daily performance of their underlying assets, which naturally draws the attention of investors seeking rebounds after a market downturn. Recently, a similar trend has emerged in the Korean stock market. Following a significant correction in Samsung Electronics and SK hynix, whose share prices had surged in a short period due to optimism about AI semiconductors, retail investors poured funds into single-stock leveraged products based on these two stocks. The expectation was that if the stock prices rebounded by the same margin as they had fallen, losses could be quickly recovered.

However, it is essential to first understand what the "2x" in leveraged ETFs actually means. Many investors believe that if the underlying index rises 10% over a certain period, the leveraged ETF will rise 20%, and that if the index returns to its original level, the leveraged ETF will also recover its principal. In reality, the structure is different. The "2x" in leveraged ETFs typically refers to "twice the daily return," not "twice the cumulative return over the entire investment period."

For example, suppose the underlying index falls 10% from 100 to 90 in a single day. A 2x leveraged ETF would fall about 20%, dropping from 100 to 80. The next day, for the index to recover from 90 back to 100, it needs to rise by 11.1%. At this point, the leveraged ETF would increase by about 22.2% (twice the daily gain), but 22.2% up from 80 only brings it to 97.8. Even though the underlying index has returned to its original value, the leveraged ETF remains at a loss. The larger the price swings, the greater this gap becomes.

This phenomenon is explained by the "negative compounding effect." Leveraged ETFs are managed to track a set multiple of the underlying asset's daily return. In a market where prices fluctuate up and down, the next day's return is calculated based on the lower price resulting from losses. The more the underlying asset oscillates, the more the cumulative return of the leveraged ETF diverges from simply being twice the cumulative return of the underlying asset.

In particular, single-stock leveraged products can be even more volatile than index-based leveraged ETFs. Unlike index ETFs, which are diversified across multiple stocks, the return on a single-stock leveraged product is heavily dependent on the movement of one company's share price. Earnings reports, business outlooks, foreign investor flows, or specific industry events can all cause large price swings in a single direction.

Ultimately, leveraged products require even more cautious investment. First, you should verify whether the rebound you are expecting is a "short-term directional move within a few days." Leveraged ETFs are more suitable for short-term trading rather than long-term holding. If you simply hold on thinking, "It will rise someday," negative compounding and volatility costs may accumulate over time.

You also need to predefine your stop-loss thresholds. If the leveraged ETF moves contrary to your expectations, losses can escalate rapidly. If the underlying asset falls 5%, a 2x leveraged product could see losses of around 10%. For single-stock products, daily price swings can be significant, so investing without a clear stop-loss plan could result in excessive volatility across your entire portfolio.

Tracking error should not be overlooked either. The ETF's net asset value and its market price may differ. Especially in volatile markets, demand may concentrate on one side, resulting in the ETF trading at a premium to its actual value. If you rush in to buy after a sharp drop, you could end up buying at an overvalued price, which means that even if you correctly predict the direction of the underlying asset, your expected return may be lower.

In the end, the key to leveraged ETF investing is not "you can double your gains if the market rebounds," but rather "if you're wrong, losses can also double quickly, and even if you're right, recovery may be slow." An official in the financial investment industry advised, "If you're investing for a rebound after a sharp downturn, leveraged ETFs can be a useful tool, but that tool is only meaningful if used over a short period and within a clearly defined stop-loss threshold."

This content was produced with the assistance of AI translation services.