Don't Let These ETFs Trick You

Some investors got a big surprise when they looked at their investment watch list today. But if you follow leveraged ETFs and see some big price moves, don't break out the champagne -- you haven't instantly become a millionaire.

Last week, the ETF provider ProShares announced that effective today, it would do reverse splits on shares of nine of its leveraged ETFs. Here's a partial list of some of the more popular ETFs affected:

Source: ProShares, Yahoo! Finance.

If you're not familiar with reverse splits, here's how they work: The company or fund essentially looks at how many shares you have and then replaces them with a smaller number of shares. Although you have a smaller number of shares, so do all other shareholders, so your percentage stake in the company or fund remains the same. Moreover, because there are fewer shares, the value of each share goes up.

Let's take a specific example. Shares of the Ultra Financials ETF closed at around $7.75 yesterday. If you owned 1,000 shares of the fund yesterday, you'll now own just 100 -- you got one share for every 10 you owned before the split became effective. But post-split shares will be worth roughly $77.50 each, so the value of your total investment should remain about the same.

What it means
Ordinarily, investors tend to associate reverse splits with stocks that are in trouble. Often, companies will execute a reverse split when their stock prices get so low that they risk running afoul of exchange requirements. In addition, some institutional investors must follow trading guidelines that make investing in low-priced securities more difficult.

With some of these funds, though, it's hard to argue that they're in trouble. The two Ultra funds listed above have seen their shares more than double since the rally began. That's not hard to understand; both the financial industry and commercial real estate have largely dodged the bullet many saw coming during the depths of the financial crisis. Investors have responded by bidding up shares of companies like JPMorgan Chase and Simon Property Group, which in turn has boosted the indexes these ETFs track.

One explanation for the reverse splits even on winning ETFs is that all of the affected funds trade near or below $10. According to ProShares, the move is meant to increase efficiency of trading -- it believes that bid-ask spreads on funds will be smaller on a percentage basis with a higher price per share, and that those who pay commissions based on the number of shares traded will see their trading costs fall.

Big drops
Unfortunately, that only raises the question of how those shares fell so low in the first place. Except for the China ETF, all of the funds listed above initially started trading at around $70 per share. The China ETF came out closer to $80.

The answer lies in the daily nature of leveraged funds. The leverage these funds use is tailored toward gaining a multiple of the daily returns of the index they track. They are not designed to mimic the long-term movements of those indexes. So if you hold onto leveraged funds for the long run, you won't automatically double or triple the movements of the market you're trying to track.

In fact, that phenomenon can turn expected profits into losses. Note that both the long and short real estate funds are on the reverse-split list. Both have dropped sharply since early 2008, even though a conventional index of real estate investment trusts has only a modest loss over the past two years and some gains since 2005.

Steer clear
Unless you're using them for their intended short-term trading purpose, leveraged ETFs don't need to be part of your portfolio. If you want long-term exposure to sectors like financials or real estate, the traditional unleveraged ETFs Financial Select SPDR (NYSE: XLF) and iShares Dow Jones Real Estate (NYSE: IYR) will give you the sector exposure you want without any leveraged surprises.

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