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 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
Leveraged ETFs have enjoyed incredible success recently. Through the magic of borrowing money and derivatives, these funds can provide investors with additional leverage to invest in the market. ProShares, for example, has a fund that seeks to double the daily return of the S&P 500. And if you're bearish, there's another fund that offers twice the inverse of that index's return.

You can get leveraged funds in particular sectors, too. Here's a sampling:

ETF

Companies Included In Tracking Index

ProShares Ultra Consumer Goods (UGE)

Procter & Gamble (NYSE: PG  ) , Coca-Cola (NYSE: KO  )

ProShares Ultra Health Care (RXL)

Johnson & Johnson (NYSE: JNJ  ) , Pfizer (NYSE: PFE  )

ProShares Ultra Industrials (UXI)

General Electric (NYSE: GE  ) , United Technologies (NYSE: UTX  ) , 3M (NYSE: MMM  )

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.

Day

S&P 500 Index Return

2X Leveraged Fund Return

1

15%

30%

2

(15%)

(30%)

Two-Day Return

(2.25%)

(9%)

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 are you'll 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:

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This article was originally published on May 30, 2007. It has been updated by Dan Caplinger, who owns shares of GE. Pfizer and Johnson & Johnson are Motley Fool Income Investor picks. Pfizer, 3M, and Coca-Cola are Motley Fool Inside Value picks. The Fool owns shares of Pfizer. Try any of our Foolish newsletters today, free for 30 days.. The Fool's disclosure policy is a hunka hunka burnin' love.


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