As they say, just because it happened somewhere else, doesn’t mean it can’t come to your own backyard. 

Case in point. An exchange-traded product (ETP) traded in London and Milan – not in the U.S. – was closed down by the fund company. 

What’s the big deal? That happens all the time in the constantly evolving business of ETFs. 

It turns out that the math involved here is what makes this situation a cautionary tale for any ETF investor considering a growing segment known as “leveraged” funds That’s where an ETF is designed to track an index, but with a multiple attached. 

To date, there have been many funds created which aim to track a return that is twice or three times that of the index. There’s even one ETF that follows the S&P 500 Index ($SPX), but with a 4X ratio.

The ETP across the pond that raised the issue of “know what you own” was a fund whose objective was to move in the opposite direction as the recently red-hot Advanced Micro Devices (AMD). With 3X leverage. Oops.

There are several 3X leveraged ETFs listed in the U.S., but none are of the single stock variety. They are all based on indexes. 

As alluded to above, the issue with these products is not apparent until something like this occurs, as with AMD. The stock rallied about 30% in a single day.

That’s great for AMD owners, and shareholders of leveraged ETFs that own AMD, such as those based on the S&P 500, Nasdaq-100 Index ($IUXX), or semiconductor industry. But for a 3X inverse fund, that type of move blows out the asset base. Instantly, in this case. Most of that AMD move took place at market open. So a -3X ETF has no chance. 

Lessons From the -3X Implosion 

1. Understand that this is always possible
2. Do not invest in a 3x leveraged fund the same way you would a traditional 1X or -1X ETF. Keep the double-edged sword of leverage front of mind.
3. Think of a -3X ETF as akin to an in-the-money put option. That is, it will move opposite the target security, it will move faster, but it can be a potentially useful hedge for some investors. That’s how I often use them. For instance, a -3X broad market ETF versus a portfolio of blue-chip stocks.
4. Learn the math of investment loss. If a stock or ETF rises by 10%, a -3X ETF will fall by a bit less than 30%, but close to it. That also means that to get back to even, you’ll need more like a 40% lift in the leveraged ETF. And if it continues to work against you, the ditch it just dug in your portfolio will get deeper.

Leveraged ETFs are like cars with a stick shift, power tools, and many other things in life that require some type of learned skill to use them correctly. They don’t have to be dangerous.

But if you treat them like gambling toys, you risk having a part of your portfolio subject to a different type of “triple witching.”