Triple Your Returns? Don't Bet on It

You want to make as much money as you can in the market. So if you're already looking for strong long-term returns on stocks, why not double or triple your bet?

That's the idea behind leveraged exchange-traded funds (ETFs). These funds are designed to magnify the movements of the markets they track. ETFs that seek to double the returns of various indexes and stock sectors have been around for a couple of years, with ETF managers such as ProShares and Rydex dominating the field. Now, in another example of the one-upmanship that dominates the ETF world, a new series of leveraged funds will go even further and try to triple the market's returns.

If you like high volatility in your portfolio, then these funds are virtually guaranteed to produce exciting price movements on a short-term basis. But if you're hoping to triple your returns over the long haul, you may be in for a nasty surprise, since leveraged ETFs won't necessarily give you the results you're looking for.

How do these things really work?
Leveraged ETFs resemble regular index ETFs in that they're geared to track the returns of a given market index. To generate ramped-up returns, however, most leveraged ETFs invest in a combination of stocks and derivatives, including options, futures, and swaps. For instance, the ProShares Ultra QQQ ETF, which tracks the Nasdaq 100 index, holds a combination of swaps and futures contracts in addition to shares of Apple (Nasdaq: AAPL  ) , Microsoft (Nasdaq: MSFT  ) , and Qualcomm (Nasdaq: QCOM  ) .

Also like regular index ETFs, you can find leveraged ETFs that cover nearly every part of the stock market. In addition to broad-market ETFs that track the Dow, S&P 500, and Russell 2000 small-cap index, you can also choose to focus on particular sectors. The ProShares Ultra Oil & Gas ETF, for example, lets you double your bet on an energy index that includes Chesapeake Energy (NYSE: CHK  ) , Transocean (NYSE: RIG  ) , and Chevron (NYSE: CVX  ) .

Finally, you can also bet against stocks by investing in leveraged ETFs. Funds such as the Rydex Inverse 2x S&P 500 ETF use short derivative strategies to make money when the market falls.

Show me the money
The key to these funds is that they all explicitly seek to double or triple the daily returns of the investments they track. Over short periods, these derivative strategies do a good job of helping leveraged ETFs achieve those intended goals.

What many investors mistakenly assume is that if you get those supercharged returns every day, you'll also double or triple your long-term return. It doesn't always work out that way.

You can see this most easily by looking at both bullish and bearish leveraged ETFs at the same time. For instance, the Nasdaq 100 has gained about 5% over the past year. Therefore, you might expect that the bullish 2x ETF would have gained 10%, while the bearish 2x ETF would have dropped 10%. Here are the actual results:

Fund

12-Month Return

Difference From 2x Index Return

PowerShares QQQ (Nasdaq: QQQQ  )

5.1%

N/A

ProShares Ultra QQQ

(0.3%)

(10.8%)

ProShares UltraShort QQQ

(14.9%)

(3.7%)

As you can see, the bull leveraged ETF lost money over the past 12 months. Meanwhile, the bear leveraged ETF lost almost three times as much as the index gained.

Easy does it
Again, to be fair, the ETF managers are quite explicit that their funds aren't intended to double or triple your long-term results. It's easy, though, to see how ETF investors might get confused when daily gains and losses don't add up to the overall profits they were looking for.

Because of the tracking error that tends to build up over time, leveraged ETFs aren't really suited for buy-and-hold investors. As with many get-rich-quick ideas, the reality can fall well short of your hopes.

The smarter course for long-term investors is to stick with more traditional investing methods, such as counting on time instead of leverage to compound your gains. Although triple-sized returns may sound attractive, buy-and-hold investors in leveraged ETFs shouldn't expect to triple anything -- except their risks.

For more on fund investing, read about:

For traditional funds that have earned supercharged returns, consider the Fool's Champion Funds newsletter service. It offers fund recommendations along with expert analysis. Want to see more? Take a free look with a 30-day trial subscription.

Fool contributor Dan Caplinger tries to stay as unleveraged as possible. He owns shares of PowerShares QQQ. Microsoft and Chesapeake Energy are Motley Fool Inside Value picks. Apple is a Motley Fool Stock Advisor recommendation. Try any of our Foolish newsletter services free for 30 days. The Fool's disclosure policy has no tracking error.


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Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On May 12, 2009, at 3:47 PM, financeguy201 wrote:

    The difference between the return of the tracking index and the return of the geared ETF is NOT tracking error. What this article is actually making reference to is the difference between the "expected return" and the actual return of the geared ETF. The "expected return" is based upon a lack of understanding of how this products actually work. The divergence is not tracking error. In fact, most of the geared ETFs, especially if they use total return swaps as opposed to futures, experience minimal tracking error. Tracking error is defined differently-- it is the difference between the NAV return of an ETF and the return of its underlying index.

    This article does rightly point out that geared ETFs are complex instruments and should be used only by sophisticated investors who understand all the moving parts and levels of risk.

    It is also important to understand fully the impact of the long term returns versus the daily returns of geared ETFs.

    Things are rarely as simple as the marketing material makes them. Investors beware.

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