Why Your 3x ETF Isn't Tripling Your Returns?

The math, mechanics, and risks of leveraged ETFs.

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Pull up a multi-year chart of a major index, like the NASDAQ 100. You'll see a long-term uptrend (at least until the time of writing this article). The natural thought for any ambitious trader follows: "If I had owned the 3x leveraged version of this, my returns would be astronomical."

So you plot the corresponding 3x ETF, and what you see is jarring. The performance over that same period doesn't just miss the 3x mark; it can seem entirely disconnected from it. In some cases, the leveraged fund might have lost value while the index gained. In other rarer cases, it might have dramatically outperformed by a factor far greater than three for a brief window.

Your first instinct is logical: you question the data. Is the chart wrong? Let me assure you, the chart is almost certainly correct. The disconnect you're seeing is the entire story of leveraged ETFs. Or as Software Engineers like to say, "it's not a bug, it's a feature". By the end of this guide, you will understand this phenomenon completely. You'll be able to look at any leveraged Exchange Traded Product and know exactly what is driving its behavior.

There is a sophisticated architecture at work beneath the simple promise of leverage, and it all revolves around a single, critical word in the fund's objective: daily.

Let's dive in.

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The Daily Reset

So, why daily? Why not a 3x weekly or monthly fund?

Daily reset is not an arbitrary choice. Offering a constant leverage multiple over a long period is a mathematical nightmare. The financial derivatives required would become impossibly complex and expensive to manage as the market moves. The daily reset is the industry's elegant solution: it simplifies the objective to a manageable, 24-hour window. The fund promises to give you 3x return today, and it starts the clock over tomorrow.

This daily reset is the core reason behind most of the counterintuitive behaviors of leveraged ETFs. It's the reason for the performance disconnect you see on the charts, and it operates with mathematical certainty.

Let's understand it with a simple, two-day scenario.

Imagine the stock you're tracking starts at a value of $100. You invest in a 2x Leveraged ETF that also starts at $100.

Day 1: The Stock Rises 10%

• The stock moves from $100 to $110. A solid day.
• Your 2x ETF delivers twice that return, rising 20% from $100 to $120. You're thrilled.

Day 2: The Stock Gives It All Back and more, Falling 10%

• The stock falls 10% from its new value of $110. A 10% loss on $110 is $11. The stock closes at $110 - $11 = $99. After two days, the stock has a total loss of 1%.
• Your 2x ETF is mandated to deliver twice the daily return, so it must fall 20% from its new value of $120. A 20% loss on $120 is $24. Your ETF closes at $120 - $24 = $96.

Let's pause and look at the result. The stock is down 1%, but your 2x leveraged fund is down 4%. You lost four times as much as the underlying stock, not two. This is the math of compounding at work on a volatile path.

This phenomenon has a name: Volatility Decay , in layperson's terms, a tax on volatility. Every time the stock zig-zags, the daily reset forces you to lock in your leveraged losses from a higher point, eroding your capital base. The more volatile the path, the higher the tax.

But this street runs both ways. In a strong, trending market with low volatility (see: trending chart above), the math can work powerfully in your favor. Let's reset the scenario.

Day 1: The Stock Rises 10%

• The stock goes to $110.
• Your 2x ETF goes to $120.

Day 2: The Stock Rises Another 10%

• The stock rises 10% from $110, which is $11. It closes at $121. The total two-day return for the stock is 21%.
• Your 2x ETF rises 20% from $120, which is $24. It closes at $144. The total two-day return for your ETF is 44%.

In this trending scenario, the stock gained 21%, and a simple 2x multiple would be 42%. Your fund actually returned 44%. This "positive compounding" is what creates those periods of explosive, better-than-expected returns.

The unavoidable conclusion is that the fund's performance is path-dependent. It's not about where the stock starts and ends, but the specific journey it takes.

Here's a good way to visualize this. Picture the stock's price (line) chart over a month as a piece of string pinned down at daily close prices. Now, imagine unpinning it completely and pulling that string taut until it's a straight line. The longer this string, more volatile was the price's journey. For a leveraged ETF, that extra length represents the decay you paid for along the way. A smooth, straight-line journey preserves your capital; a long, winding one bleeds it.

The daily reset also creates a hard, mathematical point of failure, known as the "1/L" wipeout point. For a 2x fund, a single-day market drop of 50% (1 divided by 2) will result in a 100% loss, theoretically wiping out the fund in a single session. For a 3x fund, that line in the sand is a 33.3% drop. This vulnerability is the reason why leveraged ETF prospectuses usually mention the fund manager's right to suspend trading at their discretion.

This daily rebalancing act is the fund's prime directive. To understand the costs and frictions of that process, we need to look under the hood.

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Under the Hood: The Mechanics of Leverage

When you buy a 3x leveraged ETF, the fund doesn't just borrow two dollars for every one of yours to go buy stock. That would be slow, inefficient, and incredibly expensive. Instead, they typically gain their exposure synthetically, using a sophisticated toolkit of financial derivatives. For the modern LETF, this machinery is primarily built from two components: total return swaps and futures contracts (though the 'how' is ultimately upto Fund Manager's discretion and is stated in the fund prospectus).

The Core Mechanism: Total Return Swaps

This is the most common tool used by most LETFs - a private contract with a major investment bank called a Total Return Swap.

A TRS is a "performance-for-fee" agreement. The ETF manager essentially tells the bank, "We have $100 million in assets and need 3x leverage, so we need the performance of $300 million worth of the underlying stock. We will pay you a small, agreed-upon financing rate. In exchange, you pay us the total return of that $300 million in stock for the day."

The ETF gets the pure performance without the hassle of buying and selling millions of shares. The bank takes the other side of the trade. This is how the fund achieves a precise, targeted level of exposure.

Of course, this raises a critical question: what if the bank can't pay? This is called counterparty risk, and it's a serious concern. To mitigate it, these swap agreements are collateralized. The bank must post high-quality assets (like Treasury bonds) with a neutral third party to back their side of the deal. If the trade moves in the ETF's favor, the bank has to post more collateral to cover its growing obligation.

The Liquidity Tool: Futures Contracts

Futures are standardized contracts to buy or sell an asset at a future date, and they trade on a regulated public exchange. For traders, their key feature is inherent leverage; you can control a large position with a relatively small amount of capital posted as margin.

For an LETF manager, futures offer two huge advantages over swaps:

1. No Counterparty Risk: Because the trades are cleared through a central exchange, the risk of your counterparty defaulting is effectively eliminated.
2. Deep Liquidity: The futures markets for major indexes and stocks are very deep, allowing the fund to make large adjustments quickly with minimal price impact.

The Daily Rebalancing Act

Now, let's connect this machinery back to the daily reset. Picture the fund manager's desk at 3:45 PM.

The stock your 3x fund tracks just had a great day, rising 5%. Your fund's assets are up nearly 15%. But now, the fund is under-leveraged. Its derivative exposure, which was 3x the assets at the start of the day, is now less than 3x the new, larger asset base. The fund must rebalance its positions to ensure they maintain exactly 3x.

If the stock had a bad day, the opposite happens. The fund is now over-leveraged relative to its smaller asset base, and the manager is again forced to adjust the fund's exposure to maintain the constant leverage into a falling market.

This is the daily grind of an LETF. It is a forced, systematic trader, buying into strength and selling into weakness every single day. And as any trader knows, all of this activity—the financing, the trading, the constant adjustments—comes at a cost.

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The Slow Bleed

While the daily rebalancing creates a constant drag on the fund's value, it isn't the only thing affecting your returns. To trade these products effectively, you should understand exactly what you're paying for.

The Expense Ratio

This is the most visible cost. It's the annual management fee the fund sponsor charges, usually listed as a percentage (e.g., 0.95%). For a complex product like an LETF, this fee is always higher than a simple index fund (due to reasons we already discussed above). But this is just the tip of the iceberg.

The Cost of Leverage

This is the big one. When the fund enters a swap agreement to get 3x exposure, it's effectively taking out a loan for the leveraged portion of its portfolio. That loan has an interest rate, typically a benchmark like SOFR plus a spread.

Let's put that in perspective.

• A 3x LETF has $100 million in investor assets.
• To get 3x leverage, it needs $300 million in market exposure.
• The financing fee is calculated on the leveraged portion, which is $200 million.

If the all-in financing rate is say, 7% per year, the annual cost is 0.07 * $200,000,000 = $14,000,000.

Now, here's the crucial part: that $14 million cost is charged against the fund's $100 million asset base. That translates to a staggering 14% annual performance drag from financing alone. This leverage financing meter is running every single day whether the market goes up, down, or sideways.

An interesting side note here: it matters what underlying benchmark for financing rate the leveraged ETF uses, for instance SOFR is typically over 3% cheaper than Bank Prime Loan rate. So, a 3x LETF using Bank Prime rate as the benchmark rate for financing costs would lose over 6%+ per year in value compared to one using SOFR (all else equal). Although nobody should be holding these products for long anyway.

The Cost of Constant Churn

Every trade has a cost. For an LETF, which is a forced, systematic trader, these costs are a permanent feature of its existence.

• Bid-Ask Spreads: Every day, when the fund manager buys or sells futures to adjust leverage, they have to cross the bid-ask spread (depending on how they are structured). Over time, this accumulates and drags the return down.
• Futures Roll: Futures contracts have expiration dates. To maintain exposure, the fund manager must periodically sell the contract that's about to expire and buy one for a later date. This is called "rolling." In most market conditions, the longer-dated contract is slightly more expensive than the one about to expire (a state known as "contango"). This means the fund systematically sells low and buys high, creating another small but persistent headwind against performance.

These costs, combined with the volatility decay we discussed earlier, are why an LETF's value can wither away even in a flat market. This leads us to one of the most critical and misunderstood concepts in the world of ETFs.

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Tracking Error vs. Performance Divergence

Suppose you hold a 3x fund for a month. The underlying stock is up 10%, but your fund is only up 20%, not the 30% you expected. Your first thought might be: "This thing doesn't track the stock/index well."

This is the single greatest point of confusion when it comes to leveraged ETFs, and it is completely wrong. The fund does not have a tracking error. In fact, its tracking is likely almost perfect.

You are witnessing two entirely different phenomena.

1. Technical Tracking Error: This is a measure of how well the fund achieves its stated objective on a daily basis. If the stock is up 1.00% today, the 3x fund is supposed to deliver a 3.00% return. If it actually returns 2.97%, that 0.03% gap is the daily tracking difference. It's caused by the costs and frictions we just discussed. By this metric, most LETFs are incredibly precise. Their managers are experts at hitting that daily target with minimal deviation.
2. Performance Divergence: This is the large, cumulative gap you see on a chart between the fund's long-term return and the simple multiple of the stock's long-term return.

The long-term performance gap you see is the direct and unavoidable result of the fund doing its daily job. The relentless daily reset, which the fund executes with near-perfection, is the mechanism that causes the long-term return to diverge due to the mathematics of compounding and volatility decay.

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Market Reflexivity: The Tail Wags the Dog

When you take into account the cumulative effect of multiple large leveraged ETFs on the same underlying stock or index, it seems plausible that their combined rebalancing affects the price of the underlying stock/index in a reflexivity loop. In short, reflexivity is a feedback loop where the actions of market participants impact the market's prices, which in turn changes the participants' subsequent actions. The LETF rebalancing cycle is a perfect, automated version of this. The market's own price movement triggers a forced, mechanical action that then feeds back into the price, amplifying the original move.

Here's how this reflexive loop works.

On a Strong "Up Day"

• Leveraged Long ETFs: Their assets have grown. To maintain their leverage target on this larger base, they are forced to buy more derivatives into the close.
• Leveraged Inverse ETFs: Their assets have shrunk. To get back to their target leverage against a smaller asset base, they must reduce their short exposure by buying it back.

This is the part that surprises most traders. On a strong up-day, the reflexive loop forces both the bulls and the bears to be on the same side of the market. Both long and inverse funds are net buyers into the close.

On a Strong "Down Day"

• Leveraged Long ETFs: Their assets have shrunk. They are now over-leveraged and are forced to sell derivatives.
• Leveraged Inverse ETFs: Their assets have grown. They are now under-leveraged in their short position and are forced to sell more derivatives to increase it.

Once again, the loop is synchronized. On a strong down-day, both long and inverse funds are net sellers, adding weight to a falling market.

This behavior is inherently pro-cyclical. It buys into a rising market and sells into a falling one, acting as an accelerant rather than a brake. This structural reflexivity is one of the key systemic risks these products introduce to the broader market, although worth noting that at the time of writing this, no LETFs are large enough (in comparison to their respective underlyings) to meaningfully influence the price.

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Buyer Beware

In the United States, the key watchdog for sales practices is the Financial Industry Regulatory Authority, or FINRA. Their job is to make sure the firms and brokers selling you these products are doing so fairly. Back in 2009, FINRA issued a landmark regulatory notice.

"inverse and leveraged ETFs typically are not suitable for retail investors who plan to hold them for more than one trading session"

While regulators issue public alerts, the most definitive disclosure comes from the fund itself, in a legally binding document called the prospectus. It's a dense, lengthy document, and buried within its pages is the fund's own admission of every risk we've discussed. It will explicitly state its investment objective, and you will always find that critical, five-letter word that governs its entire existence: daily. This would be a good time to ask "Who's gonna read all that?" and the perfect time for me to answer with, "We recently launched a service that reads every single prospectus from every single ETF and extracts deep insights from those. You should give it a try"

Tax Considerations

Leveraged ETFs are generally taxed unfavorably as compared to non-leveraged ETFs. The author is not qualified to comment on the taxes, but this is something one should seek out a proper advice from their tax professional.

Conclusion: A Tactical Tool, Not an Investment

Leveraged ETFs are built to decay over time. The combination of daily resets causing value decay in volatile markets, plus the constant bleed from high financing costs and other expenses we discussed, means you're fighting a losing battle if you hold on for too long.

They are not a broken product - just that their use is to get tactical exposure for very short periods of time, not to HODL.