Leveraged ETFs have gotten a lot of attention lately. Although the fund companies that produced them have thrived from their popularity, that party may soon be over.
Unfortunately, many investors don't fully understand how these vehicles work. Leveraged ETFs are designed to deliver some multiple of the daily performance of whatever underlying index the ETF tracks. But over time, daily movements in the underlying index can create losses for those who hold shares over longer periods of time -- even if the index rises on the whole.
For instance, say you pay $1,000 for a leveraged ETF when the underlying index is at 1000. The index drops 10 points every day for 10 days, and then rises 10 points every day for the next 10. With a standard index ETF, you'd be back to break-even. But with a leveraged 2x ETF, you would actually have a small loss. And even more strangely, an inverse leveraged 2x ETF would have exactly the same loss. So far in 2009, that effect has pushed many pairs of leveraged funds, such as the Direxion Daily Financial Bull 3x ETF (NYSE:FAS) and the Direxion Daily Financial Bear 3x ETF (NYSE:FAZ), down in tandem.
Even Wall Street is taking a step back
Regulators recently voiced concern over the sustainability of these investment vehicles as long-term investments. The independent regulatory organization FINRA warned about the risks of inverse and leveraged ETFs this spring, stating that they are "unsuitable for retail investors who plan to hold them for longer than one trading session, particularly in volatile markets."
In response, many of the big cats on Wall Street have either stopped selling leveraged ETFs, or placed restrictions on sales. Fidelity and Schwab (NASDAQ:SCHW) have warned investors about using them, while UBS (NYSE:UBS) and the Morgan Stanley Smith Barney joint venture of Morgan Stanley (NYSE:MS) and Citigroup (NYSE:C) have simply stopped selling them for the moment.
Are they bad?
I believe there are cases in which leveraged ETFs can give short-term investors a powerful way to seek profits. They can be effective if you understand them, and if you use them the way they're supposed to be used. But they're simply not structured for the average individual investor with a long-term horizon.
Whether leveraged ETFs will survive depends on whether there's a real market for risky short-term investments. If you want to make a long-term investment, though, you'll almost certainly do better just steering clear of them.
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