Leveraged ETFs and the Perils of Compounding: A Strategic Reassessment in Volatile Markets

The allure of leveraged exchange-traded funds (ETFs) has long captivated investors seeking amplified returns in volatile markets. Yet, as recent academic and industry analyses underscore, these instruments are fraught with risks that defy intuitive expectations, particularly when held beyond their intended short-term horizon. The compounding effect of daily rebalancing, a core mechanism of leveraged ETFs, often leads to performance decay in choppy markets, eroding returns and amplifying losses in ways that many investors fail to anticipate according to research. This dynamic has been starkly illustrated in the crypto asset space, where leveraged ETFs tied to Bitcoin have suffered catastrophic drawdowns during downturns, despite the underlying asset's inherent volatility as documented.

The Compounding Conundrum

Leveraged ETFs are engineered to deliver multiples of an index's daily returns, but their design assumes a reset of leverage each day. Over longer periods, this daily compounding interacts perversely with market volatility. For instance, in a market that fluctuates up and down by 5% daily, a 2x leveraged ETF would not merely return 10% up and 10% down each day. Instead, the compounding effect causes the fund to underperform the target index, a phenomenon known as "volatility decay". Srinidhi Kanuri and James Malm's research further confirms that these funds exhibit statistically negative alphas under both CAPM and Carhart four-factor models, rendering them suboptimal for long-term strategic asset allocation according to SSGA analysis.

Retail investors, in particular, are vulnerable to these pitfalls. As Mike Khouw of Openinterest.Pro notes, many treat leveraged ETFs as if they were simple leveraged versions of traditional ETFs, unaware of the compounding mechanics that can erode capital over time as highlighted. This misalignment between expectations and outcomes has led financial experts to caution against their use in passive, long-term strategies.

Alternatives to Leverage: Diversification Through Innovation

Given these risks, investors must seek alternatives that align with the principles of strategic asset allocation. Managed futures ETFs, market-neutral strategies, and commodities-based funds emerge as compelling options. These instruments offer low correlation to traditional assets, hedge against macroeconomic shocks, and provide returns unanchored to equity or bond market cycles.

Managed futures strategies, for example, employ trend-following algorithms to take long and short positions across global markets. The Simplify Managed Futures Strategy ETF (CTA) and Invesco Managed Futures Strategy ETF (IMF) exemplify this approach, with allocations to commodities, interest rates, and currencies. In 2025, CTA attracted over $570 million in inflows, reflecting its role as a diversifier in 60/40 portfolios according to ETF Trends. Similarly, the Neuberger Berman Commodity Strategy ETF (NBCM), which invests in 28 commodities, has been recommended for a 5% allocation in strategic asset allocation frameworks to hedge inflation as reported.

Market-neutral funds, such as the AGF U.S. Market Neutral Anti-Beta Fund (BTAL), further insulate portfolios by exploiting relative mispricings between long and short positions. These strategies, as demonstrated by the Global Finance Journal, can enhance risk-adjusted returns by hedging sector-specific risks, particularly during earnings announcements according to research.

Strategic Allocation in Practice: Balancing Risk and Return

The integration of alternative ETFs into strategic asset allocation requires a nuanced approach. LPL Research's 2025 Strategic and Tactical Asset Allocation Committee (STAAC) recommends allocating 1–2% to managed futures ETFs and 5% to commodities, depending on risk tolerance according to LPL Research. This framework acknowledges the structural shifts in traditional diversification-such as the breakdown of the stock-bond correlation due to inflation and monetary policy-by incorporating assets with uncorrelated return streams.

For instance, gold and silver, which appreciated by 33.94% in 12 months by April 2025, serve as both inflation hedges and volatility buffers according to Aequifin. Meanwhile, infrastructure ETFs, with their durable cash flows and inflation resilience, offer another layer of stability in portfolios exposed to geopolitical uncertainty as noted.

Conclusion: A Call for Prudence and Innovation

The risks of leveraged ETFs in volatile markets are not merely theoretical; they are empirically validated by compounding decay and behavioral misjudgments. As strategic asset allocation evolves in response to persistent inflation, geopolitical tensions, and shifting monetary regimes, the reliance on alternative ETFs-managed futures, commodities, and market-neutral strategies-becomes not just prudent but necessary. These instruments, when allocated thoughtfully, can transform volatility from a threat into an opportunity, ensuring portfolios remain resilient across cycles.

Investors must, however, approach these alternatives with the same rigor applied to traditional assets. The days of treating leveraged ETFs as passive, long-term holdings are over. In their place, a disciplined, evidence-based allocation to alternatives offers a path forward-one that balances ambition with caution in an era of uncertainty.