For years, analysts have warned investors about the dangers of using leveraged ETFs for anything other than a short-term play in the market. Yet during 2013, leveraged ETFs actually worked well as a buy-and-hold instrument. What's behind the sudden effectiveness of leveraged ETFs, and will their newfound success last into 2014? Let's take a look at just how these investment vehicles managed to fulfill the expectations that even those who ignore the ETFs' own warnings still have.
The ins and outs of leveraged ETFs
Despite sincere and strong efforts among leveraged ETF managers to educate their shareholders about the short-term nature of their investment mandates, many investors still look to leveraged ETFs as a way to multiply long-term returns. So when the stock market jumps 25% in 2013, owners of doubly leveraged stock market ETFs expect 50% returns. Historically, those expectations have been quashed most of the time, as the roller-coaster rides up and down during a given year eat into the effectiveness of daily tracking leveraged ETFs to meet long-term expectations like that.
Yet this year, the lack of volatility and the almost solely unidirectional moves in many markets have made leveraged ETFs a smart play even for long-term investors. Take the following examples:
- Financial stocks did extremely well in 2013, with one sector ETF rising 35% over the past year. The triple-leveraged Direxion Daily Financial Bull 3x (NYSEMKT:FAS) did even better than tripling that return, soaring more than 120% over the same period.
- On the bearish side, many commodities fell sharply this year, with the price of silver bullion on the spot market falling about 36%. While the iShares Silver Trust (NYSEMKT:SLV), matched that overall negative return, the inverse-leveraged ProShares UltraShort Silver (NYSEMKT:ZSL) more than matched its goal of doubling the inverse of that return, climbing 76% over the past year.
- For broad-market bullish investors, ProShares Ultra S&P 500 (NYSEMKT:SSO) gave investors a 66% return over the past year, doing far more than doubling the 30% return that unleveraged S&P ETFs earned over the same period.
The best of markets for daily rebalancing
The reason all these ETFs did so well this year is that conditions were perfect for daily leverage. Leveraged ETFs perform the worst when markets move in tight ranges, as repeated moves upward and downward slowly erode their value because of the daily resetting that these ETFs have to do as part of their overall strategies.
By contrast, this year, markets moved straight up for several days or even weeks in a row with few offsetting corrective moves. Under those conditions, leveraged ETFs can outperform their double- or triple-return goals because the daily resetting actually opens the possibility of exponential gains. That's what we saw in 2013, and it's why the funds mentioned here and many more like them did so well.
What will 2014 bring?
The question that leveraged ETF investors have to ask in 2014 is whether the market will keep moving in one direction without fail. So far, the market has defied long-held beliefs that a correction is imminent. That makes it possible that stocks could keep heading higher, making 2014 another banner year for leveraged ETFs.
Whatever you do, though, keep in mind the aspects of the leveraged ETFs you own and how they'll respond to changing market conditions. If you start seeing the more typical churning motions in market prices that can be so destructive to leveraged-ETF returns, make sure you stop seeing them as a smart long-term holding and remind yourself of their inherent short-term characteristics.
Fool contributor Dan Caplinger has no position in any stocks mentioned. You can follow him on Twitter: @DanCaplinger. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools don't 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.