Leveraged ETFs

1. A leveraged ETF is designed to double or triple the return of the index it tracks, up or down. The leverage works both ways. If you are correct in your analysis and believe a particular market is going to go up, you could indeed double your return. If you are wrong, however, things are going to get bad quickly.
2. The second important concept to remember about leveraged ETFs is they are designed to double or triple the return of the index they track on a daily basis. These leveraged ETFs are not meant to be buy & hold instruments. It is important to differentiate the idea of doubling or tripling a daily return versus doubling or tripling a long-term return. Most self-directed investors look at investments for the longer-term time horizon. The nature of leveraged ETFs is not conducive to investing for the long term; they are strictly short-term investment plays. The concept of leveraged ETFs is easily understood, but the complexity lies in how these leveraged ETFs actually work.

UNDER THE HOOD
Leveraged ETFs use derivatives such as index futures, equity swaps, and index options in order to double or triple the return of the market they track. I mentioned earlier that leveraged ETFs double or triple the return of the market they track daily because they reset it daily. Management will have to hold an equal amount of debt and equity at all times.

Simply put, if the fund tracks go down, the fund will have to sell shares in order to reduce its debt level. If the index goes up, the fund will have to buy shares. A leveraged ETF will incur a lot of expenses from this daily resetting. Over a long period of time, the performance of these leveraged ETFs will diverge from the index that the fund was set out to track. This is why a long-term approach to these indexes is a gigantic mistake. It is best described in a prospectus: “Over the course of a year, a fund using triple leverage for a long exposure to an index experiencing 20% volatility would lose 11% of its value even with no net change in the index.” Clearly, this is not an ETF you can buy and hold as a long-term play.

• Short-term trading — If you are tracking an index and believe the index will go higher or lower that day, you can use leveraged ETFs to quickly capitalize on this short-term move.
• Using derivatives — Most self-directed investors and traders will not be able to add the power of derivatives to their portfolio without a lot of hassle. Leveraged ETFs allow you to profit if your analysis is correct using derivatives.

The bad:
These funds will incur lots of management fees due to the daily rebalancing of the fund that other ETFs just won’t have.

• Leveraged ETFs can be dangerous — If you are an investor who doesn't understand the potential for losses in these ETFs, you could see massive losses quickly even if the tracked index is slightly down or trading sideways.
• Thinly traded — Some leveraged ETFs are not heavily traded, so closing a position could be a problem. It is critical that a potential investor look at trading volumes of the leveraged ETF that he or she is interested in. With new leveraged ETFs appearing all the time, you will need to keep a close eye on trading volumes.
• Short-term play — These are ETFs that, because of daily resetting, can cause compounding losses to mount if an investor decides to buy and hold onto a losing position. Even if the index that the leveraged ETF is tracking is trading sideways, you could still see a loss in your leveraged ETF. Losses can mount fast if the investor is not careful.

The ugly:
Due to their popularity, leveraged ETFs have come under scrutiny recently from both politicians and financial regulators. This is all in an effort to protect an investor who may believe these funds are something they are not. They are not long-term buy & hold ETFs. If an index is up 10% for the year, this does not mean the ETF will be up 20% or 30%. Both the Securities and Exchange Commission (SEC) and Financial Industry Regulatory Authority (FINRA) have warned individual investors that these leveraged ETFs are not buy & hold instruments. They feel that while the current prospectuses do indeed point out this fact, they feel that more information and a clearer message needs to be delivered by these leveraged ETF companies. Recently, Massachusetts has decided to review the sales practices of the leveraged ETFs.

THINK SHORT TERM
Leveraged ETFs have been used by savvy daytraders and investors since 2006. Self-directed investors and traders who plan on incorporating leveraged ETFs into their investment strategy need to learn all they can.

That said, if you have a short-term index strategy, a leveraged ETF can be a fantastic tool. All powerful investments need to be understood before being used appropriately.

SUGGESTED READING
Devcic, John [2009]. “Get Shorty,” Technical Analysis of STOCKS & COMMODITIES, Volume 27: November.