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For impatient investors looking to score on big short-term price movements, leveraged ETFs seemed like the product of their dreams. Yet leveraged ETFs created problems that turned many of those dreams into nightmares.
Now, though, the search for safer leverage is back. Barclays (NYSE: BCS ) has rolled out a line of exchange-traded notes (ETNs) that promise to fix the biggest flaw that leveraged ETFs have.
Going beyond daily
Traditional leveraged ETFs were designed to track daily movements of market indexes. For instance, if the Dow rose 1% on a given day, then a double-leveraged ETF pegged to the Dow should go up 2% in value. Similarly, an inverse double-leveraged ETF would fall 2% with a 1% rise in its benchmark index.
The daily emphasis that traditional leveraged ETFs used, however, caused a problem for longer-term investors. Over time, if a market zigged and zagged back and forth, then leveraged ETFs would often lose value -- even if the overall market went in the direction it was supposed to go.
That created situations where pairs of leveraged ETFs, one bullish on a market and the other bearish, would both lose value. For instance, over the past three years, the ProShares Ultra Oil & Gas ETF (NYSE: DIG ) , which is bullish on oil and gas stocks, has lost 57% of its value, while its bearish counterpart, ProShares UltraShort Oil & Gas ETF (NYSE: DUG ) , is down 72% since 2007.
Similarly, volatility among financial stocks has given sector-linked leveraged ETFs trouble. ProShares Ultra Financials (NYSE: UYG ) is down 3% in the past year, while ProShares UltraShort Financials (NYSE: SKF ) has fallen 21%. Triple-leveraged financial ETFs have done even worse: the bullish Direxion Daily Financial Bull 3x (NYSE: FAS ) is off 15% since last year, while the bearish Direxion Daily Financial Bear 3x (NYSE: FAZ ) has dropped a much steeper 35%.
The easy fix?
Clearly, the problem with daily leveraged ETFs was that long-term investors were misusing them. But the fact that so many investors had problems showed that there was strong demand for a leveraged product that would work over the long haul.
That's the demand that Barclays is trying to address with its ETNs. The new products allow long-term investors to make bullish or bearish bets on a wide range of popular indexes, including the S&P 500, Russell 2000, and MSCI indexes on developed and emerging markets.
Unfortunately, deciphering how the ETNs work is anything but easy. The returns are based not only on changes in the underlying index and the particular leverage factor of the ETN but also by what's called the constant financing rate. The prospectus goes through several examples, many of which show that even when the underlying index goes up, investors won't receive the simple leveraged return they'd expect. In a nutshell, if short-term interest rates rise, the notes could lose value even if the index goes up.
That makes sense from one perspective. Leverage involves borrowing money, and if interest rates rise, it costs more to borrow. So expecting not to pay up for leverage if borrowing costs rise isn't realistic.
Time to move on
What even the overly simplistic examples in the prospectus show, though, is that these ETNs won't give you an easy, automatic way to multiply your returns. With 293 pages of materials in the prospectus and associated supplements, it's incredibly difficult to get a good handle on exactly how these notes work. After all the lessons from the financial crisis, the last thing any investor should want to buy is something they don't understand.
Moreover, unlike ETFs, ETNs expose investors to the credit risk of the issuing bank. Although you may reasonably think Barclays is unlikely to collapse, many would have said the same of Lehman Brothers before the financial crisis hit.
Whether these ETNs actually give investors the leveraged returns they expect will depend on exactly how the market reacts. But you shouldn't volunteer to be the guinea pig for these new products. Let others jump in before you get a rude awakening on how these products actually perform in real life.
Tune in every Monday and Wednesday for Dan's columns on retirement, investing, and personal finance.