The Riskiest Investments on Earth

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.

Buyer beware
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.

 

Index

Daily Percentage Move

Theoretical 3X Bull ETF Price

Theoretical 3X Bear ETF Price

Monday 110 10% 130.00 70.00
Tuesday 90 (18.2%) 59.09 108.18
Wednesday 92 2.2% 63.03 100.97
Thursday 95 3.3% 69.20 91.09
Friday 100 5.3% 80.12 76.71

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.

For ProShares UltraShort Silver (NYSE: ZSL  ) and ProShares Ultra Silver (NYSE: AGQ  ) , the key to understanding the ETFs is in each fund's overview (emphasis in original):

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.

Fool contributor Travis Hoium does not have a position in any company mentioned. You can follow Travis on Twitter at @FlushDrawFool, check out his personal stock holdings or follow his CAPS picks at TMFFlushDraw.

Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.


Read/Post Comments (9) | Recommend This Article (16)

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 June 23, 2011, at 2:38 PM, jimmy4040 wrote:

    Good post. The best way to use leveraged ETFs is as a hedge against other investments for people who don't like options for whatever reason.

  • Report this Comment On June 23, 2011, at 3:27 PM, RickRickert4MVP wrote:

    You've been sitting on this article for awhile. I remember you schooling our Finance class in 2009 with this.

  • Report this Comment On June 24, 2011, at 7:09 AM, Sunny7039 wrote:

    If you examine the chart, you can also see how it is possible to make quite a bit of money in a very short time. But the risk is very large.

    It's interesting to me that anyone can buy these ETFs, but various other strategies (including options, access to an IPO, foreign bonds) that are safer as far as I can see may not be available from your "full service" broker. Also, some brokerages will not approve you for more than portfolio insurance (buying puts or covered calls).

  • Report this Comment On June 24, 2011, at 10:33 AM, TMFFlushDraw wrote:

    @Sunny7039

    Good point. That doesn't seem to make a lot of sense.

    Travis Hoium

  • Report this Comment On June 24, 2011, at 11:27 AM, BMWMIND wrote:

    In general, I agree that the use of leveraged ETF's is not suitable as a bare investment.

    I use ZSL as a hedge against my physical silver holdings. Options on the SLV are possible, I just spend less on ZSL to get the double down effect on the losing days.

    ZSL has made it possible for me to continue to hold physical silver. In fact I am now adding to my physical holdings and buying more ZSL.

    ZSL helps me sleep at night.

  • Report this Comment On July 02, 2011, at 8:56 AM, esicio wrote:

    A very poor analysis. Regardless of leverage, a percent move downwards is more costly than a percentage move upwards. Why? because you only have 100% to fall, but can increase infinitely. Leverage increases the effect. An exaggerated 18% downward move would require a 22% increase to compensate, WITHOUT leverage. Your convoluted example misleadingly suggests that the simple long is whole after an upward move of 10.9%, but a) it isn't whole, because the actual drop is from 110 and b) it's actually a move of 11.2 due to compounding.

    The 3x ETF drops a heart stopping 54.6% on that day. Speaking of stopping, it probably would have been stopped long before it dropped 54% , but let's not let exchange rules interfere with the story. To make up this loss, it would have to make 120%, which requires 40% growth of the base security. Well, that's unlikely to happen in three reasonable trading days, any more than an 18% drop would happen in one.

    The 3X short reflect the same problem in reverse. Sure, the 18% drop translates to a 54.6% gain, but this is hardly builds much of a profit cushion after the exaggerated 30% loss the prior day ( it requires a 42% gain to recover a 30% loss).

    Sooooo...I agree that if the stock is on a random walk, both leveraged investments are losers. But if the leveraged funds are on the right side of the trend, exactly the opposite would be the case

  • Report this Comment On July 05, 2011, at 10:39 PM, whateveryoudo wrote:

    I have been investing since November missed the run up in September bought a bunch of stocks that tanked that were good investments then tried the leveraged investment option and have been more satisfied with the results of that arena. I would buy shares of a stock put a 10% stop on it and the stock would drop 10% and would return to an even higher high. It almost seems like when you put a stop on a stock the dealer knows what your hand is. I don't use stops anymore, If I need a stop I don't need to buy that product.

  • Report this Comment On July 19, 2011, at 5:34 PM, Mega wrote:

    "Given enough time, assuming a market doesn't head straight up or straight down forever, daily return leveraged ETFs tend to head toward zero."

    This is false to the point of requiring a retraction. QLD for example has beaten SPY over the last 1, 3 and 5 years, and backtesting shows it would have beaten SPY over multiple decades. Many other 2x and 3x leveraged long ETFs have shown the same behavior.

  • Report this Comment On July 24, 2011, at 2:53 AM, darylzernick wrote:

    What am I missing on this? It seems if you buy SOXS or FAZ for instance on the market open of a day you know the market is going to go down, you can make some very nice gains by trading out of it the moment the market will goes back up?

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