How Did All These ETFs Drop in 2011?!

Exchange-traded funds have made it possible for investors to do things they never could before. But for one class of ETFs, the only thing they seem to do is something most investors don't need any help doing: lose money.

Leveraged ETFs came to market with one goal in mind: boosting returns for investors willing to take on higher risk to make gutsy calls on the direction of particular markets. Yet while the instruments have performed admirably in doing exactly that for extremely short-term traders, long-term investors have found that in many cases, the ETFs offer only a no-win scenario.

A big misunderstanding
When leveraged ETFs first came out, they started out slowly. With most markets in bull mode, investors were likely earning enough profits from conventional investments to satisfy them. But when the financial crisis hit and stocks went into bearish hibernation, leveraged ETFs became popular. In particular, inverse leveraged ETFs, whose value went up when its target index went down, made huge profits for traders who bet on the big plunge in stock markets worldwide.

But for many, the temptation to chase performance led to a fundamental misunderstanding of how the ETFs worked. In order to provide the appropriate leverage, ETFs chose to target daily returns. That made the ETFs well-suited for day-traders, but for long-term investors, it made them inappropriate and dangerous investments that were vulnerable to the simple laws of mathematics.

A bad year for leveraged ETFs
2011 had all the worst attributes for leveraged ETFs. Although there's been plenty of volatility, most markets have essentially gone nowhere, with many major indexes hovering near the unchanged level for the year. But because of the way leveraged ETFs see their value erode from daily volatility, you can find several bull/bear ETF pairs for which both funds lost money. Here are just a few examples:

Source: Yahoo! Finance.

You can plainly see the effects of owning leveraged ETFs for long periods of time. No matter whether you bet on bullish moves or bearish ones, you can end up losing money. And the phenomenon is particularly strong when markets move up and down sharply without ever establishing a true long-term direction.

Use the right tool
To be fair, leveraged ETFs have gotten increasingly clearer about their optimal short-term holding periods. Direxion even worked the word "daily" into its ETF names, while ProShares prominently explains how its ETFs focus on the single-day returns of the benchmarks they track. So by now, investors don't have any excuse for not understanding the potential pitfalls of leveraged ETFs.

Moreover, the same phenomenon that erodes returns in sideways markets can enhance them during strong markets. For instance, the ProShares Ultra 20+ Year Treasury ETF is actually up more than twice the total return of the regular Treasury ETF tracking the same index. That's because Treasuries have essentially moved almost straight up this year, with hardly a hiccup even over a long span.

But the key takeaway for long-term investors is this: Unless you're willing to bet on a market moving firmly in one direction without many bumps or corrections along the way, then leveraged ETFs may not work even if you make the right general call about the market. That's a bet most investors shouldn't be willing to make.

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