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Exchange-traded funds have become one of the most popular ways to invest in the world today. There are ETFs that follow everything from the S&P 500 to financial stocks and emerging markets. With ETFs, it's easy to make bearish or bullish bets on many indexes based on where you think they're headed.
For those willing to take more risk, fund companies like Direxion and ProShares offer a variety of leveraged ETFs for investors. You can make leveraged bear and bull bets on a variety of investments. But the one thing you need to know most about leveraged ETFs is that most seek to follow daily returns of the index they track.
Too many investors don't know how compounding affects a fund's performance. The emphasis on daily returns results in a mathematical canyon. Given enough time, assuming a market doesn't head straight up or straight down forever, daily return leveraged ETFs tend to head toward zero. That isn't to say a fund won't skyrocket over a period of time, but Foolish long-term investors should be aware of the dangers. Let me give an extreme example to show how the math works out:
Take a hypothetical situation involving an index and two leveraged ETFs, each starting at 100. Over the course of one week, the index moves every day but ends the week at 100 again. Look at what happens.
Daily Percentage Move
Theoretical 3X Bull ETF Price
Theoretical 3X Bear ETF Price
Both ETFs followed 3X the daily gains and losses, and the result is that both decline over the week. These moves are exaggerated by high percentage moves in the example, but a similar trend plays out in the market given enough time and volatility.
Consider some popular pairs of bullish and bearish leveraged funds. Since the end of November 2008, immediately after their inception, Direxion Daily Financial Bull 3X Shares (NYSE: FAS ) has lost 53% of its value, while Direxion Daily Financial Bear 3X Shares (NYSE: FAZ ) is still down more than 2%.
Similarly, just since the beginning of the year, Direxion Daily Emerging Markets Bull 3X Shares (NYSE: EDC ) is off almost 18%, while Direxion Daily Emerging Markets Bear 3X Shares (NYSE: EDZ ) was down more than 2%. For buy-and-hold investors, there was no way to win with these leveraged ETFs.
The main lesson is this: Even if the index you're tracking goes nowhere, both bullish and bearish funds can lose value over the longer term.
Read before you leap
When buying any ETF, it's important to read the overview each fund releases, if not the full prospectus. The overview is generally very short and to the point, and it can often tell you everything you need to know about an ETF.
This ETF seeks a return of 200% [for AGQ; -200% for ZSL] of the return of a benchmark (target) for a single day. Due to the compounding of daily returns, returns over periods other than one day will likely differ in amount and possibly direction from the target return for the same period.
Reading these documents may not your favorite thing to do on a Saturday afternoon, but if you're investing in ETFs it can make all the difference in your investment performance.
Foolish bottom line
If you already knew how daily leveraged ETFs worked, this compounding quirk may not be a surprise. But not all investors have a great understanding of how ETFs function. For instance, 63% of all Motley Fool CAPS investors have given ProShares UltraShort FTSE China 25 (NYSE: FXP ) an outperform rating despite the long-term likelihood that shares will eventually be headed downward, as the math above shows. By contrast, 69% of CAPS All-Stars have picked the ETF to underperform. Maybe that's part of the reason they're All-Stars.
ETFs are a very efficient way to invest, but some investors have gotten into funds without knowing the facts first. It doesn't take long, and it'll help your returns in the long term if you take some time to read the prospectus and educate yourself before clicking buy.
Want to know what else Fools are saying about these ETFs? Add them to our free My Watchlist and we'll find all of our Foolish analysis of your favorite ETFs.
Invest in better ETFs. Read the Fool's special free report on ETFs to get the names of three great funds to help boost your core portfolio's returns.