Leveraged ETFs: Buyer Beware!

Leveraged ETFs have gotten a lot of attention lately. Although the fund companies that produced them have thrived from their popularity, that party may soon be over.

Unfortunately, many investors don't fully understand how these vehicles work. Leveraged ETFs are designed to deliver some multiple of the daily performance of whatever underlying index the ETF tracks. But over time, daily movements in the underlying index can create losses for those who hold shares over longer periods of time -- even if the index rises on the whole.

For instance, say you pay $1,000 for a leveraged ETF when the underlying index is at 1000. The index drops 10 points every day for 10 days, and then rises 10 points every day for the next 10. With a standard index ETF, you'd be back to break-even. But with a leveraged 2x ETF, you would actually have a small loss. And even more strangely, an inverse leveraged 2x ETF would have exactly the same loss. So far in 2009, that effect has pushed many pairs of leveraged funds, such as the Direxion Daily Financial Bull 3x ETF (NYSE: FAS  ) and the Direxion Daily Financial Bear 3x ETF (NYSE: FAZ  ) , down in tandem.

Even Wall Street is taking a step back
Regulators recently voiced concern over the sustainability of these investment vehicles as long-term investments. The independent regulatory organization FINRA warned about the risks of inverse and leveraged ETFs this spring, stating that they are "unsuitable for retail investors who plan to hold them for longer than one trading session, particularly in volatile markets."

In response, many of the big cats on Wall Street have either stopped selling leveraged ETFs, or placed restrictions on sales. Fidelity and Schwab (Nasdaq: SCHW  ) have warned investors about using them, while UBS (NYSE: UBS  ) and the Morgan Stanley Smith Barney joint venture of Morgan Stanley (NYSE: MS  ) and Citigroup (NYSE: C  ) have simply stopped selling them for the moment.

Are they bad?
I believe there are cases in which leveraged ETFs can give short-term investors a powerful way to seek profits. They can be effective if you understand them, and if you use them the way they're supposed to be used. But they're simply not structured for the average individual investor with a long-term horizon.

Whether leveraged ETFs will survive depends on whether there's a real market for risky short-term investments. If you want to make a long-term investment, though, you'll almost certainly do better just steering clear of them.

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Jennifer Schonberger does not own shares of any of the companies mentioned in this article. Charles Schwab is a Motley Fool Stock Advisor selection. Try any of our Foolish newsletters today, free for 30 days. The Motley Fool has a disclosure policy.


Read/Post Comments (17) | Recommend This Article (13)

Comments from our Foolish Readers

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  • Report this Comment On August 05, 2009, at 2:07 PM, bombardtim wrote:

    I'm not a math wiz but I wish you'd explain why it doesn't get to back to even. Ten days of 20 pt swings (double the ten) equals 200 each way. You don't say why it doesn't. What I do know is if the market goes down 10%, you buy in and it gets back to the same level you make MORE than 10%. I started buying FAS and URE, now UYM for the long term. I put in roughly 15,000 between a Roth and some personal funds and have doubled my money since earlier in the year.....sure the swings have been incredible but if you believe in long term recovery doesn't it make sense? Even if it doesn't exactly equal the 2X or 3X isn't it still a good index play if you think the indexes will eventually rise? If the FAS (banking index) keeps rising and the leveraging only gets me 2.5X return is that really awful? Maybe it goes the other way and I lose 3.2X, is that the issue? Help me understand my error......

  • Report this Comment On August 05, 2009, at 2:16 PM, MoreInfoPlease1 wrote:

    I concur, bombardtim.

    Ms. Schonberger said, "They can be effective if you understand them and use them the way they're supposed to be used."

    But her explanation was only that both the bull and the short funds can go down over more than one day.

    Tsk tsk

  • Report this Comment On August 05, 2009, at 3:05 PM, ExFAZPlayer wrote:

    Actually, Motley Fool's math is incorrect as well. After 20 days, the underlying security would be at $1000, +2X Daily ETF would be @ $997.78, and the -2X Daily ETF would be at $993.40. Do the math yourself. The dif is that each day the +/- is rest and is a daily 2X the % difference in the underlying security. Goind down, 10 points is a greater % of the prior days down price (<$1,000), so the net overall % is greater for -NX ETFs ... thus the erosion.

    Day Underlying Daily +2X % Daily -2X %

    1 $1,000.0 $1,000.00 $1,000.00

    2 $990.0 $980.00 $1,020.00

    3 $980.0 $960.20 $1,040.61

    4 $970.0 $940.61 $1,061.84

    5 $960.0 $921.21 $1,083.74

    6 $950.0 $902.02 $1,106.31

    7 $940.0 $883.03 $1,129.61

    8 $930.0 $864.24 $1,153.64

    9 $920.0 $845.66 $1,178.45

    10 $910.0 $827.27 $1,204.07

    11 $900.0 $809.09 $1,230.53

    12 $910.0 $827.07 $1,203.19

    13 $920.0 $845.25 $1,176.74

    14 $930.0 $863.62 $1,151.16

    15 $940.0 $882.20 $1,126.40

    16 $950.0 $900.97 $1,102.44

    17 $960.0 $919.93 $1,079.23

    18 $970.0 $939.10 $1,056.74

    19 $980.0 $958.46 $1,034.96

    20 $990.0 $978.02 $1,013.83

    21 $1,000.0 $997.78 $993.35

  • Report this Comment On August 05, 2009, at 3:32 PM, lglzdgmbln wrote:

    Yeah yeah yeah. I think this angle has been already covered by just about all of the talking heads. The key is the trend of the market while you own it. If the market is in a clear trend (regardless of time frame) the 2/3x ETF's will perform pretty close to what is expected. If the market is flat then you will underperform.

  • Report this Comment On August 05, 2009, at 4:12 PM, FarrahFawcett wrote:

    THEY ARE PERFECT !!!!!!!!!! You just have to know how they work.You can make a tonne of money if you use them for trends. Only idiots and most of CNBC stupids, including Erin "Pinocchio" Burnett and Mark "The Cow" Hainz don't understand them.

  • Report this Comment On August 05, 2009, at 5:24 PM, 789pol wrote:

    This the sort of stuff that brought Enron down. It is basically the old shell game and the only person making any money is he who pushes the shells around and around. You can not trade air for air. No substance. And by the way, I have a nice antique bridge for sale.

  • Report this Comment On August 05, 2009, at 8:36 PM, Mathguytwo wrote:

    EZ FAZ Player is correct - the overall erodes. Both funds opened around 50 and eroded to under 10 dollars each. Get it, over time House wins!

    Personally I have been winning on the bull market. Bought FAS at 20 - now it's at 70. And after a few good days of FAS run up, I buy FAZ to hedge for a few days. Sure enough FAZ heads up, when I hit 10% I sell.

    It's worked well up until this last couple of week where we have had such a bull run. Hedge din't work, just didn't make 100% profits, but am still making a chunk. Especially as FAZ heads farther down, dails loss is smaller everyday and daily profit on FAS is greater everyday.

  • Report this Comment On August 05, 2009, at 9:13 PM, DeeRaz wrote:

    I'm a printer by trade. My 401K was invested in Mutual funds and "managed by professionals".

    From November 2007 to March 2009, it went from $98,000 to $50,000. On March 5th, I took Full responsibility (Key Word) for my Money and began trading in and out of the (FAS) and (FAZ), Never holding either for more than 5 days straight. My Portfolio is over $550,000 as of 8/5/2009. To Quote Jim Cramer "Do Your HomeWork" before you invest! or leave it to the "professional money managers" ( Now there's an Oxymoron!) to lose it for you.....We are NOT Children. Inform us so we can make choices. Don't call for a ban. Thats for Totalitarian Regimes like (Iran and China). America is about Free Choice! If TD Prevents me from trading the etfs of my choice, I will imediately pull my account and find One That Will. Stop Blowing "Cramer's Horn" on leveraged etfs. Let's not Forget he Also "Protected" us from Investing in China in 2006-2007. OUCH!!!!!!!!!!!!!!!!!!!

  • Report this Comment On August 05, 2009, at 11:12 PM, IRAWinner wrote:

    guys, great discussion. glad to see other stories out there of people using these products to rebuild their portfolios succesfully. This has been a great run and having leveraged ETFs has been hugely beneficial. Personally, I don't care whether the math ultimately delivers hypothetical returns of $997 vs. $993. To me, whether or not the ETF tracks roughly close is plenty to make enormous returns. I still view a leveraged basket of securities (ie index or sector funds) to be less risky than owning shares of an individual company subject to fraud, product recall, labor strikes, etc. The past is littered with individual stocks going to essentially zero (WaMu, Enron, etc.) I'm still trying to read the article that can explain why holding leveraged ETFs is more risky had any other security,

  • Report this Comment On August 06, 2009, at 12:45 AM, Stopthisplease wrote:

    I agree with the comments about what we are not children.

    The most people understand the risks of the instruments traded.

    I can see from many medias now one campaign anti-ETF's, this is just when FAS had a nice rally and the markets need to begin to go south fast.

    I think what the government will make every effort to disrupt the possibility of the people to make good money in this direction how for example FAZ,SKF,SMN,BGZ,TZA...In other word intervention and nothing of free market.

    Then ban short selling and may be to say what the puts are prohibited because the time decay!!

    Because they worry about the investors:-)))C'mon!!!

  • Report this Comment On August 06, 2009, at 9:23 AM, ExFAZPlayer wrote:

    FAS3X -

    You grew from $50k to $550k in 5 months trading FAS (and some FAZ) = 1,100% growth! How much did you lose on FAZ betting the market would tank in the past 3 weeks?

    If you hold these, they will erode. If you can guess (2-3 days max) what direction the market will go, you can make a lot of money fast, but if you're wrong, you'll lose it quickly as well. Most important is to evaluate ONLY the underlying security or index, in this case $RIFIN. Reviews its charts, compoents, etc. to decide what will happen next. Charts on the derivative Daily ETF's are of NO value.

    I'm avoiding it right now, but FAZ & ERY look pretty good right now ...

  • Report this Comment On August 06, 2009, at 2:35 PM, DelphiJoe wrote:

    Why would FAS be a risky long term investment when the underlying individual stocks of the financial index, i.e. the banks and other financial institutions, are rising in value? Sure, its swings, both up and down, are more pronounced than non-leveraged investments, but if you think the economy is in recovery and stocks will rally then you should expect the financial sector to participate in the upswing.

    If you believe the financial sector has been oversold and is bound to recover most, if not all, of its former value in the long term then FAS should be a good long term investment.

    Check out its performance before the collapse of the financial market. I think the negative opinions of FAS are those of late comers who missed a unique opportunity early this year and would like to scare people into selling their FAS holdings.

  • Report this Comment On August 06, 2009, at 2:44 PM, DelphiJoe wrote:

    This post is from Andrew, not from DelphiJoe

    Why would FAS be a risky long term investment when the underlying individual stocks of the financial index, i.e. the banks and other financial institutions, are rising in value? Sure, its swings, both up and down, are more pronounced than non-leveraged investments, but if you think the economy is in recovery and stocks will rally then you should expect the financial sector to participate in the upswing.

    If you believe the financial sector has been oversold and is bound to recover most, if not all, of its former value in the long term then FAS should be a good long term investment.

    Check out its performance before the collapse of the financial market. I think the negative opinions of FAS are those of late comers who missed a unique opportunity early this year and would like to scare people into selling their FAS holdings.

  • Report this Comment On August 06, 2009, at 3:06 PM, ChannelDunlap wrote:

    So the same people who wouldn't stop people from buying GM's stock after they repeatedly said it would be worth nothing, are stopping people from buying leveraged ETF's because they might not be good long term investments? Makes perfect sense to me!

  • Report this Comment On August 11, 2009, at 3:50 AM, marc9l wrote:

    Leverage ETFs and their false and ignorant critics.

    Most articles from “advisers or experts“ show a total lack of basic mathematical understanding.

    Well, these supposed experts should take a course in basic mathematics before making uneducated and ignorant statements trying to influence lawmakers in their decisions and understanding.

    If an index trades at 100 and its leverage 300% ETF is also at 100, when the index goes down 30%, the result will be that the index is now at 70 and the 300% leverage ETF at 10. (3*30 = 90)

    Now if the index goes up by 30% from 70 it will only go up to 91 and not 100, and by the same token the 300% ETF from 10 will only go to 19 (30%*3 = 90% 10 + 90%= 9)

    So to be amazed that they have not recovered to their initial price shows a total lack of understanding and basic mathematics skills, therefore these people should not only “not be advisers” but should be sued for spreading “false and misleading information”.

    If the lawmakers use this ignorant logic to make new laws, they should be send back to high school to be taught basic mathematics, instead of, passing new laws about financial products they obviously do not have a clue about.

    Marc

  • Report this Comment On August 11, 2009, at 9:09 AM, CofusedAgain wrote:

    Which bank stocks - and at what % - make up the FAS stock

  • Report this Comment On August 31, 2009, at 11:11 PM, CaptainFiveBaggr wrote:

    I call BS on FASx3- lol 1100% trading both FAS & FAZ in 6 months---- would make this guy nostradamus. not some unemployed college age kid who claims to have flipped an imaginary $50K into $550K. Lose the pipe dream and get a job. I agree 100% with taking charge of your own money, but reckless market timeing big bets is no way to "invest" with 401k money.....dont be an idiot.. be a FOOL

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