These Investments Just Don't Work

Schemes that offer people the chance to get rich quick never seem to go out of style. And while the market has historically offered investors the chance to earn steady, solid returns over the long haul, some folks just don't want to wait.

That explains the appeal of exchange-traded funds that let you multiply your returns over those of particular indexes or sectors of the market. And while you might think that magnifying your gains could only help your cause in the long run, the reality proves much more disappointing.

Great for short-term plays
What's behind this fundamental misunderstanding of these ETFs? The problem is that while the leveraged ETFs hold themselves out only as delivering on their promises over very short periods of time -- typically a single trading day -- some investors misuse them by holding them for longer periods.

At first, that seems to run counter to the Foolish idea of holding investments for the long run rather than trading frequently. But to be a good long-term holding, an investment has to be designed to be held for a long time -- and that isn't the case for these ETFs.

Heads I win, tails you lose
The results make these ETFs look like a no-win scenario for investors. Consider these returns since the beginning of the year:

ETF

Strategy

YTD Return

Ultrashort Financials ProShares (NYSE: SKF  )

2x Bearish Financials

(31.6%)

Ultra Financials ProShares (NYSE: UYG  )

2x Bullish Financials

(49.7%)

Direxion Daily Energy Bull (NYSE: ERX  )

3x Bullish Energy

(40.2%)

Direxion Daily Energy Bear (NYSE: ERY  )

3x Bearish Energy

(6.2%)

Ultrashort S&P 500 ProShares (NYSE: SDS  )

2x Bearish S&P 500

(0.8%)

Ultra S&P 500 ProShares (NYSE: SSO  )

2x Bullish S&P 500

(17.4%)

Source: Yahoo Finance. As of April 20.

You'd think that by choosing a particular market or sector, you'd at least stand a chance of making a winning bet. But even a relatively short period of a few months is long enough to make an investment that's designed to be held for only a day or so break down from what investors might expect -- and it's quite possible that everyone ends up a loser.

A closer look at how these ETFs work explains a lot. In order to produce magnified returns, these ETFs often use a sophisticated derivative known as a total return swap. The time period of those swaps defines the appropriate holding period for the ETF. Theoretically, it should be possible for an ETF to make transactions that would produce two or three times the annual return of an index or sector -- although it might be more costly for the ETF.

In appealing to short-term investors, though, these ETFs aren't targeting shareholders with that kind of long-term focus. So they really only work well for day traders.

Get what you want
A good sign, though, is that people seem to increasingly understand these trades. One brokerage firm reports that many customers trade in and out of these ETFs in just a matter of hours.

Nevertheless, these ETFs serve as another example of how you have to research every investment decision you make. It's not enough to think you understand how an investment works, or to take a brief glance at the name or description of a particular security. Rather, you need to be diligent in poring over your investments to ensure they'll behave as you expect.

Obviously, everyone would like to make back as quickly as possible some of the money they've lost recently in the market. ETFs that promise double and triple returns, however, don't fit the bill for long-term investors looking to make solid investments. While these ETFs may make a useful tool for short-term traders, you'll be better served sticking to traditional funds and ETFs like the SPDR Trust (NYSE: SPY  ) ETF -- and the slower but steadier returns they offer over time.

For more on ETF investing, read about:

Learn more about ETFs and fund alternatives with our Motley Fool Champion Funds newsletter. A free trial is yours for the asking for 30 days.

Frustrated with your 401(k)? Even if your employer's plan isn't the greatest, you don't have to give up your dreams of a happy retirement. Get the tips you need to turn your retirement savings around in our special report, "How To Make The Most of Your 401(k)" -- just click here for instant free access.

Fool contributor Dan Caplinger is steering clear of leveraged ETFs. He owns shares of SPDRs. Try any of our Foolish newsletters today, free for 30 days. The Fool's disclosure policy may be silly, but it gets the job done.


Read/Post Comments (10) | Recommend This Article (22)

Comments from our Foolish Readers

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 April 21, 2009, at 6:14 PM, ronjon31 wrote:

    SKF is down to $60.30 at days end, where does everyone see this going in the next week/month?

  • Report this Comment On April 21, 2009, at 10:52 PM, tomd728 wrote:

    ronjon,

    On the SKF I wish I had an answer.The piece from

    MF is certainly accurate in return % (or lack thereof)

    when these ETFs are held for long term: e.g. one

    year for arguments sake.

    In addition there are other features of these ETFs that

    do not reflect real return if one were short every financial in the basket.....That being impossible they

    do play a role if one is speculative or if you use

    to offset a serious long position of one or several

    financials.

    I have probably written what you already know but

    I include that scant information in any event.

    I held the SKF today buying right after the open and

    I got my head handed to me.On 4/20 I was long as

    well and bailed on a *trailing stop.I did very well.

    It is as the piece mentioned a day trade but only so

    as the financials have been a yo yo in the Markets.

    "The Trend Is Your Friend" ? These financials have

    yet to show any bias up or down.

    Me? I think there is a lot more pain in here for these banks but not on the day Geithner is addressing the

    posers on that committee.They should have pinned

    his ears back but that was irrelevant as I never considered the calming effect to the group of stocks

    and guys smarter than me (on this day) made hay

    in the opposite ETF.

    *Never use one on a day trade.

    I hope I helped you amigo if a bit long winded.

    Tom

  • Report this Comment On April 22, 2009, at 9:38 AM, thismarketrox wrote:

    Um, short them?

  • Report this Comment On April 22, 2009, at 12:02 PM, motleyfool1234 wrote:

    The numbers is this article are accurate, but I do have a problem with the article. I believe that the UYG ETF should be used for longer term basis. It is abviously down YTD as most of the financials. But the EFT takes away the risk of owning individuals companies that can go bankrupt. I don't care about the UYG EFT day to day movements, but where it's going. Since the march low it has doubled. As the financials improve, the ETF will rise. Just look at it's historical chart.

  • Report this Comment On April 22, 2009, at 6:02 PM, tomd728 wrote:

    1234

    Thank you and I will look at it.

    I am loathe to leave some short instrument as I believe there is hell to pay in the financials save the

    "old line" investment bankers GS MS JPM.

    I had responded to ronjon, as you see, and today

    was another stomach churning event...catch the bias...don't overreach....and the gains can be very

    rewarding.

    Tom

  • Report this Comment On April 30, 2009, at 8:33 AM, michael54321 wrote:

    Do the yr to date return on spy versus sso, its down 24% compared to 11%, although these etf's will MAY not deliver exact 2x over long term they will outperform, both to the downside and upside . more informed writers on seeking alpha about this trade

  • Report this Comment On April 30, 2009, at 1:00 PM, Bingstone wrote:

    I agree with motleyfool1234 in that some ETFs are excellent vehicles for long term investments. But I think UYG (2x) is not as good as XLF (1x) for financial investors, not because of the multiples but of stability and reliability. I watch them closely.

  • Report this Comment On April 30, 2009, at 1:58 PM, ForexFool wrote:

    Leveraged ETF's can work quite well to hold long term. The biggest criticism of them is that because they are 3X leveraged, they amplify what is referred to as decay - that is if you buy at $10 and it goes up 20% one day to $12, then down 20% the next day, you end up at $9.80 not back at $10.

    The solution? Just sell them short and make the decay work for you. In fact, in a ranging market, you can short both the Bear and the Bull 3X ETF and make money. If the market begins to trend, you'll lose money but not nearly as much as if you where holding the only the bear or the bull and you were holding the wrong one.

    Now step back and take a look at the big picture. We are in a huge recession. Equities have taken a huge hit the past 18 months and come back somewhat the past month. If a trend does develop over the next 12-18 months, what will it most likely be a bull or a bear? Obviously a bull.

    So I contest that if you sell short the 3X bear funds, you'll make money in a ranging market because the decay works for you when you sell short, and when the bull trend develops, hold on for the ride of your life. The only big risk is if a short-term pullback arises and the market takes say a 20% hit, aka the double dip, in that case you may have to live through a 40-50% drawdown on your investment. Hard for most people to stomach but just hold on, it will come back and the decay and 3x leverage will work for you.

    The problem a lot of people don't like to sell short as they equate it to betting against a company. But if you sell short a bear ETF you are actually in a long position but protected against decay if the market continues to range.

    Also the fact you don't hear a lot about this strategy is everyone thinks 3X funds are only for day traders. Day traders are trading for a living and/or entertainment (like going to the casino). If a day trader holds their position, then they don't have the capital anymore to make their day trading exciting and/or they can't pay their bills because they aren't generating enough income when having to hold a position for the long term.

    I think selling short the FAZ or the TYP and holding it for a couple years has got to be one of the best investment opportunities I've ever run across. Plus by holding it over a year you can avoid short-term capital gains tax.

  • Report this Comment On May 04, 2009, at 1:31 PM, tgauchat wrote:

    I know that the double ETFs (especially the shorts) have erosion from their goal over anything but the short term, yet, still, they provide simple leveraged returns when you need a hedging bias.

    Finding stocks available to short, these days, are difficult, let alone doing self-leveraging. Ultra-ETFs are a choice, if the investor understands that the correlation will often drift.

  • Report this Comment On May 24, 2009, at 11:34 PM, guiron wrote:

    There's not enough good news left to keep the rally going. We're almost at the end of earnings season. Jobs numbers are not good and getting worse, loads of car dealerships are just starting to announce closures, and we will likely see a contraction in discretionary spending throughout the summer as more jobs are shed. We will test the bottom again in the next few months and then see a rally in the fall or winter. No telling if it will be another bear rally or the beginning of the next bull rally. But I think we're done with this bull, really a rally in a bear market, because we're about at the end of what the fundamentals can support even with the most optimistic outcome.

    Shorting the Direxion 3x bear sounds like suicide from this entry point. I'm long the bear etfs until later this year, especially financial, small cap, emerging, and long energy and gold/silver as a hedge, though we could see a pullback in gold and oil again before inflation and rising interest might have a chance to gain traction. But if our treasuries fall by the wayside, look for interest rates to rise and inflation to start kicking in to pay our debt in a stagnant growth market.

    There is a lot of downside to the financials yet to work through, particularly credit card debt defaults and repercussions of new regulation, prime-rated and commercial mortgage defaults, fallout from a crippled auto industry, an overinflated bond market and plenty of bad news to accompany a long summer. OTOH, if the pullback is slow then the ultra bears will not perform as well, which is why I also like SEF and other regular inverse funds, as the decay doesn't have as much effect. Other equities are going down or sideways for a while. But I keep the dividend paying energy stocks as well as some gold/silver and take profits elsewhere, starting this week and into the beginning of June.

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