Leveraged ETFs

These Wall Street products take a simple idea and make it way too risky for ninety-nine out of a hundred investors. The simple idea is the Exchange Traded Fund, or ETF. These are index funds. Unlike mutual funds that trade only at the end of the day, ETFs can be bought and sold throughout the day. ETFs can provide an easy way to own an investment that traces the performance of a market index like the S&P 500.

The complexity, and thus the risk, comes when you marry ETFs with futures (or other derivatives) and/or debt to try to juice up gains. For example, a so-called 3x “Bull” ETF might aim to use leverage to get triple an index’s gain each day. On the flip side, derivatives can be used to make an investment that will perform inversely to a given index. Thus, a Pro-share Ultra-Short “Bear” S&P 500 is designed to go up three times the amount by which the S&P 500 goes down on a given day.

Leveraged ETFs are usually based on an index’s performance on a given day instead of over time. For example, if you own a regular index fund and the index rises 10% on day one but then drops 10% on day two, your $100 investment would go up to $110 and then drop to $99, for a $1 loss. But if you own a 2x leveraged ETF on the same index, and the index goes up 10% on day one, you have $120 at the end of the day. So far, so good. But if, as in the previous scenario, the index drops 10% on day two, you would lose $24 ($120 minus 20%). This leaves you with only $96, which means you lost $4 instead of $1.

There are lots of problems with leveraged ETFs. Leverage increases gains, but compounds risks. If, for example, you take a 3x bet that the Japanese stock index goes up, and instead it drops 10% because of the big earthquake, you just lost 30% of your money in a day.

Other problems with leveraged ETFs include the fact that, in some instances, the ETF may trade at a premium to the actual index it tracks, especially if it is tied to an exotic index. There are also some very specialized indices that are, themselves, fraught with risk. For example, there are ETFs based on commodities, currencies, gold, silver, bonds, specific country markets, and the VIX, which measures the volatility of the S&P 500 index. Just because it’s an index doesn’t mean it’s safe.

According to Paul Justice, an ETF research analyst at Morningstar, “Leveraged ETFs kill portfolios” and “are probably too complex for most individual investors.” FINRA issued a June 2009 warning that “inverse and leveraged ETFs that are reset daily typically are unsuitable for retail investors who plan to hold them for longer than one trading session … .”

The lowdown of leveraged ETFs is that they are not suitable for buy and hold investors, folks who don’t day trade, or those who don’t fully understand their risks. On the last point, we would venture an informed guess that not many clients (or brokers) can appreciate the real risks.