The Worst Investment on the Market Today

No one really knows what the market is going to do tomorrow. If they did, there would be many more billionaires than there are former day traders. The fact of the matter is that day-to-day movements on the market can be dramatic, illogical, and come seemingly out of nowhere. That's why, at The Motley Foo,l we focus our attention on stocks you can buy and hold for years.

Today, I'd like to caution you about one of the most dangerous investment instruments on the market: leveraged ETFs. It isn't that leveraged ETFs don't have a place -- for example, they can play a role for traders trying to hedge against something -- but they never, ever belong in someone's long-term portfolio. They're all destined to underperform the market -- and here's why.

Daily compounding is a race to the bottom
What most people don't understand is that most leveraged ETFs are leveraged to the daily moves of the market. So, over time, the volatility of the market will eat away potential returns.

Take the example below of triple daily levered bull and bear ETFs that follow an index. The index closed Friday at 100, and each ETF also closed Friday at $100. Over the course of the week, the index gyrates around, and closes the following Friday at the exact same level. Meanwhile, the ETFs triple the daily moves of the index on the bull side, and are negative the daily move's percentage on the bear side.

 

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

Notice what the daily leverage does to returns of the leveraged ETFs. Instead of ending at the same level as a week before, they're both significantly lower after a week of volatile trading.

This phenomenon takes place in any ETF that tracks the daily performance of an index. Given enough time, they're all destined to move toward zero.

Killing long-term returns
The dangers of these instruments can be seen long term in ETFs that follow the Dow Jones Industrial Average (DJINDICES: ^DJI  ) and the S&P 500 (SNPINDEX: ^GSPC  ) . ProShares Ultra Dow30 (NYSEMKT: DDM  ) is the 2X bull ETF that follows the Dow, and ProShares UltraShort Dow30 (NYSEMKT: DXD  ) is the 2X short version. You can see that since 2006, they've both vastly underperformed the Dow itself, even though the Dow is up 66.9%. 

DXD Total Return Price Chart

DXD Total Return Price data by YCharts

The same goes for ProShares Ultra S&P 500 (NYSEMKT: SSO  ) and ProShares UltraShort S&P 500, which have both underperformed the S&P 500.

SDS Total Return Price Chart

SDS Total Return Price data by YCharts

Stick to long-term investing
Whether you think a leveraged ETF is a shortcut to quick gains, or you're trading it on a daily basis, it's important to understand how each ETF works, and what its disadvantages are. No matter what, leveraged ETFs aren't meant to be investments you buy and hold for years on end. I've shown above that that's a way to underperform the market no matter which side you're betting on.

Stick to solid dividend stocks
Dividend stocks can make you rich. It's as simple as that. While they don't garner the notoriety of high-flying growth stocks or ETFs, they're also less likely to crash and burn. And over the long term, the compounding effect of the quarterly payouts, as well as their growth, adds up faster than most investors imagine. With this in mind, our analysts sat down to identify the absolute best of the best when it comes to rock-solid dividend stocks, drawing up a list in this free report of nine that fit the bill. To discover the identities of these companies before the rest of the market catches on, you can download this valuable free report by simply clicking here now.


Read/Post Comments (3) | Recommend This Article (7)

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  • Report this Comment On September 14, 2013, at 9:08 AM, GW1000 wrote:

    Travis, do you consider DIA to be a good ETF? It has been a good investment for me, although I was fortunate enough to buy it at the bottom of the recent financial crisis.

  • Report this Comment On September 16, 2013, at 12:13 PM, weicky wrote:

    Travis,

    I bought SSO four years ago and as of today I have more than 2X the S&P return as a result of the upward bias amplifying my returns. I agree with you - you need to understand how the ETF works - however your article failed to point out the situations that can work to the investor's benefit.

  • Report this Comment On September 27, 2013, at 4:39 PM, psych4biz wrote:

    Travis this is yet another in the doom and gloom pieces I have read about leveraged ETFs, which do not play out in reality over several years. At the peak of the financial crisis I bought UYG, the double long Dow financials ETF. It went down after that and bottomed in March 2009 like everything else, but has behaved very well since then. I take comfort from a spreadsheet which I created, which tracks UYG against its index and tries to predict its behavior and various ups and downs. I am beating the spreadsheet handily so far and tracking almost exactly 2:1 against the index. Your short term examples may be correct but like your other readers here, that is not my experience over several years. I will hold until it is much higher, let's say a very conservative one third of its level during 2007? That would be $250, versus less than $100 today.

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