Assets in exchange-traded funds have been growing just as quickly as they have been shrinking in actively managed mutual funds. Investors disillusioned with highly paid but poorly performing active managers are finding a lot to like about low-cost market-trackers like ETFs. But not all exchange-traded funds are created equal. In fact, some may offer more distractions than true benefits to investors.
I have long warned investors about the potential dangers of leveraged and inverse leveraged funds. These funds typically use financial derivatives such as options and futures to leverage the fund to increase the return (or inverse of the return) of the underlying index and give fund performance a boost. It wasn't long before triple-leveraged funds became available, offering investors three times the daily return of the tracked index. While this may sound like a sure way to make a few extra bucks on the market's movement, such funds are frequently more dangerous than investors realize.
Apparently, Morningstar is starting to see these funds in much the same light. They recently announced that they were considering moving inverse and leveraged funds from their current broad fund categories and placing them in a separate group. With this move, they would also no longer rank these funds on the one- to five-star rating system currently used for other mutual funds. Morningstar indicated that these funds were closer to being "trading vehicles" rather than investment vehicles, which is what their star rating system is meant for.
Place your bets
If Morningstar does go through with their plan to stop assigning star ratings to leveraged and inverse funds, I think that will be a good thing for investors that rely on Morningstar's research. I concur with idea that these funds are not long-term, buy-and-hold investments, and as a result, they are likely to end up hurting many investors. Despite the two major bear markets in the past decade, the stock market tends to go up more often than it goes down, typically ending up roughly every two years out of three. That means that inverse funds are likely to lose money over the long-run, and the only way to profit is to engage in market timing at exactly the right times, something that investors are notoriously bad at.
Furthermore, because leveraged funds typically track the daily return of their intended indices and not the annual return, returns can be far worse than investors expect under certain situations. For example, Direxion Daily Financial Bear 3X Shares
Unfortunately, in light of the stock market's recent troubles and investors' general attitude of risk avoidance, people are now more inclined to consider funds like these. Some of the most popular inverse and leveraged funds include ProShares Short S&P 500
If you've been tempted by the outsized returns some of these funds have put up lately, like the double-leveraged ProShares Ultra Gold Fund
If you're an ETF investor, stick to the tried and true. Invest in simple, low-cost funds that give you no-frills exposure to a wide swath of the market. It may not be as exciting as buying a fund that offers three times the daily return of the Brazilian stock market, but you also aren't likely to end up out of luck and out of money when the market moves against you.