As the market starts to wobble after its huge rally over the past six months, investors will once again turn to leveraged and inverse ETFs to try to protect their gains. Although these high-powered ETFs are best suited to those who measure their investing results over the course of days rather than years, even long-term investors can get something out of keeping their eyes on them.
The beauty of leveraged ETFs
When leveraged ETFs first came out several years ago, they seemed to give investors something they'd always dreamed of. At first glance, the ETFs appeared to offer multiplied returns on the indexes they tracked. So if you thought the market was going to rise 10%, the theory went, you should be able to buy a double-leveraged ETF and make 20%.
In addition, leveraged funds came in both bullish and bearish flavors. Inverse leveraged funds were especially attractive to many traders because they offered a way to bet on a market decline even within accounts where true short-selling wasn't typically available, such as retirement accounts. So again, if you thought the market would drop 10%, the hope was you could use a double-inverse ETF to score a 20% profit.
After a somewhat slow start, leveraged ETFs became very popular, especially during turbulent periods for the market such as late 2008 and early 2009. Average volumes for ProShares Ultra S&P 500
Fact vs. fiction
Unfortunately, investors who used leveraged ETFs for longer-term investing didn't understand the impact of the method those ETFs used to leverage their returns. In particular, because most leveraged ETFs target daily returns, the natural rising and falling oscillations in the market caused their value to erode over time.
Short-term investors didn't have to worry about those effects, but when you look at long-term results, you can see the big hit that some confused investors took on leveraged ETFs. For instance, during the past three years, the ProShares UltraShort Oil & Gas ETF
So why bother looking?
If these ETFs have done such a bad job of taking away long-term investors' money, then why should you bother putting them on your watchlist? The simple answer is that these ETFs give you a window into the behavior of a much different group of market participants than you're familiar with as a long-term investor.
It's always interesting to see how short-term traders are thinking about a particular stock. By using their tunnel-vision approach against them, you can follow their trends and turn them to your advantage, taking the opportunity to buy promising shares when they're cheap or to sell overpriced stocks before a correction takes away your gains.
Moreover, if you put inverse funds on your watchlist, you'll get to read some bearish commentary to give you the other side of a particular trade. Even if you're convinced that the bullish case is the smarter play, it's valuable to give yourself a gut check from time to time.
So as we wait to see if this brief downturn becomes an official correction -- or something more ominous -- put some leveraged ETFs on your watchlist. You may not want them in your portfolio, but keeping them on the radar will give you valuable insight into how other investors are dealing with the current market environment.
- Add ProShares Ultra S&P 500 to My Watchlist.
- Add ProShares UltraShort S&P 500 to My Watchlist.
- Add ProShares UltraShort Financial to My Watchlist.
- Add ProShares UltraShort Oil & Gas to My Watchlist.
- Add ProShares Ultra Oil & Gas to My Watchlist.
- Add Direxion Daily Financial Bear 3x to My Watchlist.
- Add Direxion Daily Financial Bull 3x to My Watchlist.
Fool contributor Dan Caplinger believes in keeping your friends close and your enemies closer. He doesn't own shares of the ETFs mentioned in this article. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Fool's disclosure policy gives you all the power.