The Easiest Way to Gamble Your Money Away

Exchange-traded funds have set the stock market ablaze. Amid growing investor demand, providers have begun offering funds in increasingly exotic flavors, focusing on extremely narrow and obscure market segments. Now, investors have the option to "double up" on their bets, with a new series of leveraged ETFs that magnify the market's gain or loss.

Is that Elvis singing in the background? Because I sure feel like I'm in Las Vegas.

Taking bets
A recent Wall Street Journal article highlighted the incredible success of leveraged ETFs. A year ago, none existed; today, more than 50 such funds collectively hold more than $6 billion in assets. Through the magic of borrowing money, these funds can provide investors with additional leverage to invest in the market. For example, the ProShares Ultra S&P 500 (AMEX: SSO) seeks to double the daily return of the S&P 500 Index, while the ProShares UltraShort S&P 500 (AMEX: SDS) offers twice the inverse of that index's return.

The house always wins
One of these funds' problems lies with investors' perception of how they work. Investors commonly think that if the underlying index returns 10% in a year, the leveraged ETF tracking that index should return 20%. But these leveraged funds work by doubling the daily return of the index, not the annualized return. To see how this discrepancy works, check out the following example.

With a leveraged fund, losses have a much bigger effect on a daily basis. Even if the index rebounds on Day 3, the leveraged fund may not make up all of its lost ground, because the losses reduced the original base from which the fund can grow. Of course, this example is unrealistic, since the markets don't typically rise and fall 15% in a single day. But over time, even small gains and losses prevent the leveraged fund from reaching its goal of doubling the index. Investors who don't truly understand how compounding works may be surprised when their leveraged fund doesn't double the index's return over any given time period.

In addition, the folks running these leveraged funds must constantly buy and sell shares of the underlying index, or futures contracts and other derivatives, to keep their leverage ratios in line. For some of these funds, that amounts to millions of dollars in purchases or sales every day, depending on how the market moves. The turnover increases expenses and transaction costs, eroding investors' ultimate returns. That can make leveraged funds much less attractive, especially for investors concerned about taxes on short-term capital gains.

Putting all your cards on the table
If these ETFs have gained billions of dollars in assets, some investors must find them worthwhile, right? Well, there are probably millions of people who visit Las Vegas every year, but I wouldn't bank on a lucky jackpot to fund my retirement. Leveraged ETFs are simply a bad gamble for most investors.

First, many folks don't understand how these funds actually work. Second, I'd guess that most investors in leveraged ETFs are merely trying to double their bets on a given market. Like so many things in life, timing is everything. If you buy a leveraged fund before a bull market, odds you'll will benefit from doubling up your bet. But if you buy right before an extended market drop, you're in for a world of hurt.

If there's a strategic business reason for you to use leverage, go for it. But if you're just trying to make some quick profits by doubling down on the market's rise or fall, face it -- you're gambling. Be smart, Fool, and save the risky bets for your next trip to Las Vegas. Just tell Elvis I said hello.

More high-stakes Foolishness:

• Using Leveraged Funds
• The Magical Land of ETFs
• The Best ETF for 2007: ProShares Ultra S&P 500

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Fool contributor Amanda Kish lives in Rochester, N.Y., and can always call a bluff. Amanda does not own shares of any of the companies or funds mentioned herein. The Fool's disclosure policy is a hunka hunka burnin' love.