Why Leveraged ETFs Are More Dangerous Than Ever

Exchange-traded funds have revolutionized the investing world, giving investors access to many different parts of the market that used to be closed to them. However, ETFs have also introduced strategies that aren't always ideal for long-term investors. In particular, leveraged ETFs aim to offer two, three, or four times the daily returns of the indexes they track. While they do a good job of accomplishing those short-term goals, many investors misuse leveraged ETFs as long-term investments.

The reason leveraged ETFs are more dangerous now than ever is that because many parts of the market have soared lately, long-term leveraged ETF investing has produced huge returns that could lull investors into a false sense of security.

Data source: Fund providers.

Why some leveraged ETFs have been doing so well lately

The preceding table shows just how strongly some leveraged ETFs have performed in recent years. Even the leveraged ETF companies themselves will say that evaluating the performance of leveraged ETFs over a five-year period isn't consistent with their short-term investment strategy, but some investors still swear by the huge returns that leveraged ETFs on the right side of market movements have produced during the bull market.

Coincidentally, the long-term returns of some leveraged ETFs closely match the misimpression that many investors have about their performance. An unleveraged ETF of financial stocks has risen by between 15% and 16% per year over the past five years, and so the 46% average annual return for the triple-leveraged financials bull ETF is completely consistent with an erroneous expectation that the fund will produce triple the benchmark's long-term results. For the S&P 500, leveraged ETFs have done even better than investors might have thought, with the 26% average annual gain in the double-leveraged Ultra S&P 500 ETF coming in more than double the 12% average annual rise in the value of the unleveraged S&P 500 index.

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This is what often happens to leveraged ETFs

The reason some leveraged ETFs have performed so strongly is that their underlying markets have moved nearly straight upward without a great deal of volatility. For leveraged ETFs, long periods of extreme ups and downs that result in the underlying market making no long-term progress are the worst possible situations investors face. When they happen, both bullish and bearish investors can lose.

The two leveraged oil ETFs in the table give an example of how this works. Oil stocks have generally risen and fallen with the price of crude oil, with big swings above $100 and below $30 per barrel taking their toll on a host of companies both big and small within the energy sector. Over the past five years, an index of energy stocks has fallen at a rate of about 2% per year. Predictably, the bullish leveraged ETF has fallen more sharply at an 8% annual pace since 2012. Surprisingly, though, the bearish ETF is actually down more, averaging a 10% drop annually over the same period.

The other aspect of leveraged ETFs that pressures prices downward over time is their expense ratio. The strategies that produce leverage have a cost, and investors pay for their exposure through higher expenses. For short-term traders, the incremental hit is minuscule, but those who hold these ETFs for the long run also see their returns suffer from having fees that in some cases can exceed 1% per year taken out of their holdings year in and year out.

Steer clear of leveraged ETFs

Leveraged ETFs aren't suitable for a long-term financial plan. Unusual market moves like the one we've seen over the past several years can make their returns look attractive, but many ETF investors have already seen the negative impact that leverage can have in the long run. The best course is to resist the temptation to be greedy and instead invest without leverage in the areas you think have the most promise. That way, you won't fall prey to financial engineering where the cards are stacked against you.