The Dangers of Leveraged ETF Investing

While leveraged ETFs may sound like a great way to double or triple your investment profits, the short-term orientation of these investment vehicles puts long-term investors at a major disadvantage.

In this Industry Focus: Financials clip, host Shannon Jones and Fool.com contributor Matt Frankel discuss the dangers of leveraged ETF investing that every long-term investor should keep in mind.

A full transcript follows the video.

This video was recorded on Aug. 13, 2018.

Shannon Jones: You've touched on it a little bit, but now, we can actually get into leveraged ETFs. Our listener question wasn't exactly focused on leveraged ETFs, but, if I'm an investor, I see that I could actually get 2-3X returns on the market, or maybe inverse of what the market is doing, why wouldn't I do that? What should I know before I consider diving headfirst into these leveraged ETFs?

Matt Frankel: First of all, it's 3X the profit potential, but also 3X the downside potential. That can magnify really fast. If an index that you're tracking drops by 20% and you're 3X levered to that, your investment drops by 60%. That's the thing to keep in mind -- greater risk, greater reward. But there's a fine line between gambling and taking a calculated risk. Inverse ETFs I would liken to gambling more than investing.

The other thing is the daily price movements that I just mentioned have a double effect when you're talking about a leveraged ETF. This is a simplified example, but, let's say that you buy a leveraged ETF with 3X leverage and the underlying index drops by 30%. You can expect your instrument to drop by 90%. In other words, you would now need to gain 900% in your investment just to break even. It really can amplify your losses, especially over long periods of time.

I would advise any listener who's thinking of buying a leveraged ETF for a long period of time to look at its past performance. You'll see that most of them lose money over time, even when the investors bet correctly, just because this daily price movement puts the investor at an inherent disadvantage over long periods of time. Over short periods of time, these can be useful instruments. But from a long-term perspective, you're at such a disadvantage. The disadvantages I talked about with inverse ETFs are magnified when it comes to leveraged ETFs.

So, keep that in mind, do your homework, and definitely have an exit strategy and a clear plan in mind if you're even thinking about touching one of these.

Jones: Absolutely. You hit the nail on the head. Shorting is risky enough. When you then add in the component of leverage, the challenge of actually making money becomes significantly more difficult in that case, especially when the markets are irrational. You talked about the daily compounding effects. That's the whole key behind this. That's why sometimes, when you see 2-3X returns, you might not actually get that at the end of the day as a long-term investor. Really, the key for using leveraged ETFs is first knowing how volatile those daily price swings are; and secondly, in which direction those price swings are going to go. Both of those factors are nearly impossible to predict, and for long-term investors, nearly impossible to keep up with.

I would say, to reiterate, leveraged ETFs really don't have a place in the portfolio of a long-term investor. If you are going to use them, make sure you have an exit strategy. Consider your stops. And really, I would even throw in, the SEC, the Security and Exchange Commission, has an investor bulletin out on this very topic -- and not just on leveraged ETFs and inverse ETFs, but also in the context of long-term investors. As a matter of fact, the title of it is, Leveraged and Inverse ETFs: Specialized Products with Extra Risk for Buy-and-Hold Investors. So, before you think that Matt and I are both just being curmudgeons on a Monday and want to suck all the fun out of your portfolios, it's not just us. The SEC warns against their use.

Really, I would say, if you are going to use them, certainly read through the prospectus. Many of these funds outline these risks. They tell you pretty much everything that we just told you in the prospectus. You want to check that out. Even in that SEC investor bulletin, they have a special section of what to look for in that prospectus, as well, if you're considering it.

Again, not that it's a terrible thing. There are many different instruments that one can use to profit in the stock market. You just want to be very much aware of the risk involved, really consider your risk tolerance as you go into some of these investments. And, at the end of the day, you want to talk with someone like a Matt Frankel, who is now a certified financial planner, to help you in making that decision.

Matt, any other final thoughts on any of these strategies?

Frankel: The one thing I'd really like to reemphasize is, if you're thinking about buying a leveraged ETF, go back and look at its performance history. The market has roughly tripled since its 2009 lows after the financial crisis. If you look at a triple-leveraged S&P 500 ETF, I guarantee you it has not tripled the market's return in that period of time.

If you look at the performance history of a leveraged ETF before you jump into it, that alone could make you think twice, in addition to the prospectus essentially telling you it's not for long-term investors. So, definitely do your homework, look at the chart, look at the prospectus, if you still decide it's right for you, at least you'll be informed.