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Leveraged ETFs: An Endangered Species?

Exchange-traded funds have made investing a lot simpler for millions of investors. But ETFs have also introduced a wide variety of previously unavailable assets to the mainstream investing world. One of the most dangerous and misunderstood sets of funds has been the leveraged ETF space, where traders seek to make big bets on fast-paced moves in a particular market.

Despite their high risk, leveraged ETFs have shown no sign of disappearing. But with a recent move by one of the pioneers of the industry to close its final two leveraged ETFs, the big question is what's behind the decision to abandon the space. Could leveraged ETFs finally be losing their appeal? Let's take a closer look.

Guggenheim gives up on leveraged ETFs
Recently, ETF provider Guggenheim Investments decided to close nine of its ETFs. Although most of the funds affected were based on specialized sectors or market cap, two of the funds were leveraged ETFs tracking the S&P 500. There's nothing all that surprising about the news in itself. Both of the ETFs had assets well below the $100 million mark, which is widely seen as the amount necessary for an ETF to survive for the long term.

But Guggenheim's decision is remarkable because of its history. As a recent article in ETF Daily News noted, Guggenheim acquired the ETFs when it bought out Rydex, which was the first company to offer a leveraged mutual fund two decades ago.

Who's left?
With Guggenheim's departure, the remaining big players in the leveraged ETF space are ProShares and Direxion. But unlike Guggenheim, both Direxion and ProShares show every sign of staying in the leveraged-ETF space for a long time.

ProShares in particular has a healthy slate of funds. Look at a list of leveraged ETFs by assets under management, and you'll find that most of the entries come from ProShares. In large part, the success of ProShares owes to its ability to offer ways to play popular trends, as its biggest funds show.

  • For years, investors have been looking for bond yields to start rising. ProShares UltraShort 20+ Year Treasury (NYSEMKT: TBT  ) promises high returns when that happens, and the fund has more than $3.3 billion in cash, along with a variety of derivative positions designed to provide returns equal to double the inverse daily return of an index of long-term bonds.
  • In this long bull market, players on both sides of the market have sought high-reward ways to play price swings. Both the bullish ProShares Ultra S&P 500 (NYSEMKT: SSO  ) and the bearish ProShares UltraShort S&P 500 (NYSEMKT: SDS  ) have more than $1 billion in assets.
  • ProShares has done a good job of providing sector-specific leveraged ETFs that allow targeted exposure to a particular industry. Many of its funds have substantial amounts of assets, with the ensuing liquidity creating a positive network effect that encourages more investors to choose ProShares over rival ETF providers.

By contrast, Direxion started out with the promise of getting even more leverage than ProShares, with its 3x funds offering triple leverage. It, too, has successfully found areas of particular interest to investors, with its best-known funds arguably being Direxion Financial Bull 3x (NYSEMKT: FAS  ) and Direxion Financial Bear 3x (NYSEMKT: FAZ  ) . With the nearly straight-up move in financials over the past year, the Direxion bullish financial ETF has produced a 78% return since this time in 2012, far outpacing the 25% return of the unleveraged SPDR financial ETF.

Leveraged ETFs aren't going anywhere
I've criticized leveraged ETFs for years for the way they have slowly but surely sapped capital away from investors on both sides of their respective markets. But fund providers have been better about highlighting the fact that these vehicles are made for short-term speculation, rather than long-term investment. Unless you're prepared to handle the immense volatility these funds promise, you'll be better off avoiding them -- but with millions of investors choosing to keep them in their portfolios, leveraged ETFs are far from endangered.

To learn more about a few ETFs that have great promise for delivering profits to shareholders in a recovering global economy, check out The Motley Fool's special free report "3 ETFs Set to Soar During the Recovery." Just click here to access it now.

Tune in every Monday and Wednesday for Dan's columns on retirement, investing, and personal finance. You can follow him on Twitter @DanCaplinger.

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