Will These Investments Get the Job Done?

During 2008's market meltdown, the poster children for failed financial innovation were leveraged exchange-traded funds. Yet during 2009's big bounce-back, some leveraged ETFs posted results showing they did at least somewhat better in achieving the returns that longer-term investors still seem to want from them.

Revisiting the controversy
As you may recall, leveraged ETFs came under fire for not performing the way some investors thought they ought to. Designed to provide daily returns that are two or three times those of certain benchmark indexes, leveraged ETFs were misunderstood by many investors who falsely believed that they'd reap two or three times the long-term returns of those markets.

Many found out during 2008, however, that leveraged ETFs didn't work that way. In fact, in several cases, pairs of bullish and bearish leveraged ETFs covering the same sector both fell over longer periods, despite the fact that they were designed to be opposites of each other in the short run.

Things can only get better -- or not
In 2009, though, you could reasonably expect to see that pattern reverse itself. After all, after an initial two months of dreary results, the market turned on a dime in March and proceeded to head higher almost nonstop for the rest of the year. Sectors like financials did particularly well, bouncing strongly off their lows. So leveraged ETFs making bullish bets should have made out like bandits, right?

Let's take a look at some leveraged ETF pairs:

Source: Morningstar.

You can see that in most cases, bullish leveraged ETFs managed to come close to their goals. For instance, with the S&P 500 posting a total return of around 26% last year, the Proshares bullish S&P fund didn't quite double the index's 2009 return, but it came reasonably close. And the bearish fund lost just about twice the percentage gain.

Similarly, with technology stocks like Apple (NASDAQ:AAPL) and Palm (NASDAQ:PALM) securing huge gains along with emerging-markets stocks such as CNOOC and Tata Motors, the performance of the bullish ETFs in those sectors was impressive, even if bears got obliterated.

Still failing on financials
Unfortunately, the woes of leveraged ETFs continued in some sectors. Among financials, for instance, the mixed performance during 2009 of winners like Goldman Sachs (NYSE:GS) and JPMorgan Chase (NYSE:JPM) with losers such as Citigroup (NYSE:C) helped to make both bullish and bearish funds fall over the course of the year. Direxion's triple-leveraged financial ETFs did even worse, with the bullish fund falling 41.4% and the bear fund plummeting 94.6%.

But leveraged ETFs overcame one other shortcoming that hurt them in 2008: capital gains liability. In 2008, even losing ETFs had to deal with huge capital gains distributions. For 2009, however, none of Proshares' 77 leveraged and inverse ETFs made any distributions, and only some of Direxion's bullish funds paid out capital gains. That largely prevented the double-hit of losses and taxes that some shareholders faced last year -- and was a definite boon for the big winners of 2009.

Worth a second look?
The fact that some leveraged ETFs provided decent long-term returns, however, can only add further fuel to the fire about the way they confuse naive investors. As long as leveraged ETFs remain tied to daily returns, it's only coincidental when their long-term returns happen to map closely with the broader market's movements.

Leveraged ETFs carry the same dangers that they did back in 2008. So don't let the strong performance of some of these ETFs trick you into thinking their long-term problems have been solved, or you could easily end up being a big loser in 2010.

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