Context colors everything, and against the current market backdrop, it's well worth asking if leveraging your investments -- i.e., what amounts to borrowing money in order to raise the stakes, whether you do it or a fund company does it with a leveraged ETF -- is ever a good idea. It costs money, you'll endure additional volatility, and it's quite possible to be crushed by leverage.
Add it up
Just ask folks who own shares of ProFunds Ultra NASDAQ-100 (UOPIX). This souped up ETF, which aims to deliver twice the daily return of the Nasdaq 100 Index, counts the likes of Microsoft
With all of those stocks deep in the red over the last year -- and with such additional holdings as eBay
Meanwhile, PowerShares QQQ (QQQQ), the plain-vanilla (i.e., non-leveraged) ETF known as Cubes that also rises and falls with the Nasdaq 100, has declined "just" 43% over the same period.
Ouch.
Do the math
But the grim numbers I just quoted don't tell the whole story. Obviously, with a leveraged ETF you court greater risk, and, in percent terms, the relative thumping noted above is painful.
In bang-for-buck terms, however, the picture is more complex.
Consider the case of an investor, who we'll call Larry, whose asset-allocation game plan for a $10,000 portfolio calls for a 10% allocation to the large-cap growth segment of the stock market. Larry would like to obtain that exposure while laying out just half the cash that would otherwise be required -- a goal Ultra Nasdaq-100 facilitates. By laying down just $500, that is, Larry is able to cut his desired slice of the asset allocation pie and -- in dollar terms -- obtain upside/downside potential similar to what he would have procured with a thousand bucks plunked down on Cubes.
Performance-wise, in fact, he even comes out a bit better. Crunching the numbers we find that if Larry had made his $500 investment in the Ultra fund 12 months ago, he would have been sitting on a loss of $368 at the close of the market day on Monday. If he had gone the $1,000 Cubes route instead, his loss would be $434.
Even in percentage terms, these numbers above appear favorable for the leveraged approach outlined above. To be fair, though, while the ProFund's downside decline hasn't been twice that of Cubes, the upside wouldn't necessarily be as sweet, either.
The cost of leverage -- the fund company pays interest on the money it borrows to leverage, and that interest comes out of your returns -- makes it highly unlikely that Ultra Nasdaq-100's goal of delivering twice the daily return of its namesake benchmark will fully translate into comparable multi-year gains. And the nasty math that attends leveraged losses is well worth reviewing, too. Simply put, these booster shots are best used in very judicious doses.
The Foolish bottom line
The associated costs and risks are of course crucial to bear in mind when contemplating leveraged ETFs -- but so too are the asset allocation benefits that savvy investors can have when using them intelligently.
Those benefits often get lost in the sometimes overheated discussion of leveraged ETFs, but it's one that we considered carefully before choosing a leveraged ETF for Ready-Made Millionaire, a real-money portfolio service that's backed by a million bucks from the Motley Fool.
If you'd like to learn more about how we've used a high octane ETF in the context of a carefully calibrated portfolio, click here to learn more about the service. We'll be open to new members early in the new year, and until then, we'll set you up with a free copy of our special report, The 11-Minute Millionaire -- a handy guide to things you need to know before investing another dime in this market.
Shannon Zimmerman doesn't own any of the securities mentioned above. Microsoft and Dell are Motley Fool Inside Value recommendations. Activision and eBay are Stock Advisor choices. You can check out the Fool's strict disclosure policy by clicking right here.
