Inside Wall Street’s Leveraged ETF Frenzy

New ETF launches are getting meta.

Roundhill launched a new leveraged product last week that targets twice the daily performance of its own computer memory fund, the Roundhill Memory ETF (DRAM), which itself has become one of the most successful launches of all time. The new T-REX 2X Long DRAM Daily Target ETF (RAM) is one of the latest in the leveraged category, which has brought in hundreds of billions in assets since the start of the year and was, according to Morningstar, responsible for over 300 new product launches last year. But why so many new leveraged funds, and why now? The answer has several parts, one being that they tend to be more lucrative for issuers than investors, said Dan Sotiroff, associate director at Morningstar.

“On the one hand, you’ve got the clients that are gambling with this stuff, they want a quick hit and a quick win,” Sotiroff said. “On the other side, you have asset managers who are going to blast 50 or 60 of these out there all at once, betting that one or two of them become wildly successful. The success of those one or two more or less subsidizes the cost of doing the 50 or 60, and they’re justified in doing that from a business perspective, because they still make money at the end of the day.”

(Fund) Death and Decay

One major feature of leveraged funds is what’s referred to as volatility decay. Decay happens when the growth of an ETF eventually “destroys itself,” Sotiroff said. That’s because when returns are levered, volatility is too. Over time, that volatility eats into the performance of the ETF. “Almost all [leveraged funds] that I’ve seen, eventually what they do is they just asymptotically approach zero over time because of that phenomenon,” he said. “As you lever more and more, that actually accelerates that whole volatility decay phenomenon, so it actually occurs faster and quicker.”

Another thing to keep in mind with leveraged and inverse products is that often, they don’t actually own the underlying stock or the targeted stock. Instead, they use swap contracts. But there are increasing numbers of products that offer direct access to things like private assets, said David Shapiro, Co-Founder & CEO of OpenVC. “There are more and more [ETFs] coming online that actually do enable folks to get these assets without the leveraged context or like derivatized context,” he added.

Hit the Brakes. The SEC in December halted filings of highly leveraged funds, defined as those with more than 2x exposure to their underlying holdings. But some experts, like Joy Yang, global head of index product management at MarketVector Indexes, said it might make more sense to loosen regulations so US investors don’t seek out the products abroad. She told ETF Upside that regulators would be better off “keep[ing] investors where they can see them.”

Sotiroff agreed, adding that investors can’t just sign up for a traditional brokerage account and start day-trading in Germany or London. “Given the riskiness of that, I tend to think that’s probably actually a good thing,” he said.