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The ups and downs of ETFs
With many types of investments, you can conceivably come up with years in which nearly everyone does well. During the amazing recovery rally in 2009, for example, markets around the world rose strongly off their lows from the market meltdown. It hardly mattered what you invested in, as nearly everything went up.
But the thing about ETFs is that in some ways, the ETF universe has become a zero-sum game for investors. ETFs often come in pairs these days, where bullish investors have an opportunity to buy into one fund, while bearish investors can take the opposite bet by buying a similar inverse fund designed to provide mirror-image results. So if you see one ETF make headlines for providing outstanding returns, then you'll want to look closely -- because lurking in the shadows, you'll likely find another ETF that has been decimated by the same market.
Looking at the list of ETF losers for 2010 makes this phenomenon strikingly clear. Each of the following 11 funds has caused long-term shareholders to lose half or more of their investment since the beginning of the year:
2010 YTD Return
|ProShares UltraShort Silver (NYSE: ZSL )||
|Direxion Daily Real Estate Bear 3x (NYSE: DRV )||
|Direxion Daily Small Cap Bear 3x (NYSE: TZA )||
|Direxion Daily Mid-Cap Bear 3x (NYSE: MWN )||
|Direxion Daily Energy Bear 3x (NYSE: ERY )||
|Direxion Daily Emerging Markets Bear 3x (NYSE: EDZ )||
|Direxion Daily China 3x Bear (NYSE: CZI )||
|Direxion Daily Latin America 3x Bear (NYSE: LHB )||
|ProShares UltraShort Russell 2000 Growth (NYSE: SKK )||
|ProShares UltraShort Russell 2000 (NYSE: TWM )||
|Direxion Dailiy Financial Bear 3x (NYSE: FAZ )||
Source: Capital IQ, a division of Standard and Poor's. Returns as of Dec. 23.
You can learn some valuable lessons from these returns.
First and foremost, the list shows you just how great a year it has been for bulls -- and the dangers of betting against stocks during a bull market. Small-cap and mid-cap stocks have performed relatively better than their larger counterparts here in the U.S., and emerging markets have maintained their popularity. But using inverse leveraged ETFs to bet against those markets has cost shareholders huge chunks of their capital. And remember -- when you take a 50% hit to your portfolio, earning a 50% positive return in the following year is not enough to get you back to even. It takes a 100% return to do that -- and 100% returns are hard to come by, even when you're talking about triple-leveraged funds.
In addition, some additional research shows how leveraged ETFs that are linked to daily returns can be dangerous for investors who hold them for longer periods of time. In many cases, the corresponding bull ETFs produced much more modest gains than the losses that these bear funds returned.
Finally, some of these funds have had bad returns for two years running. Silver, for instance, has been in a strong bull market for years, and its move upward only accelerated in 2010. If you counted on a cyclical reversal after a strong year for precious metals in 2009, you were sorely disappointed -- and your portfolio took a big hit because of it.
What to expect in 2011
It's impossible to predict whether bull markets in stocks and commodities will continue next year or reverse themselves. What is likely, though, is that leveraged ETFs like these will continue to play a prominent role on lists of both of the best ETFs of next year and the worst ETFs of 2011.
Prudent investors will likely prefer to stick with less exciting ETFs. Although you won't make the best-of-2011 list next year, the value of staying off the worst-of-2011 list should more than make up for that.