Exchange-traded funds come in all shapes and sizes. If a basket of equities or commodities exists, these days there’s an ETF that tracks it -- sometimes to the tune of twice the rate of the underlying benchmark. “Leveraged” ETFs, as they’re known, use debt to juice returns -- a great plan when the market is on the rise, but not such a sound strategy when it swoons.
And guess what? Soon, the market’s ETF assembly line will begin rolling out vehicles that step on the gas even harder, in order to deliver triple the underlying index’s daily return.
Go Speed Racer?
Our advice? Don’t get behind that wheel.
True, 3X vehicles have the potential to jolt a moribund portfolio to life. However, they could also finish it off once and for all. See, the leveraged funds double the daily return, not the annual return.
Say the market gains 10% one day and loses 10% the next. The 1X investor will have lost 1%. The 2X investor will have lost 4%. And the 3X investor will have lost 9%.
What's more, because of the expense ratio shareholders pay for the privilege of riding these bucking broncos, an investor's shot at actually doubling -- or tripling -- her money come in two flavors: slim and none.
With leveraged ETFs, the upside potential isn't quite as sweet as the downside risk is sour.
That said, I still believe there's a responsibly Foolish way to put these puppies to good use. Indeed, I run point on a Fool service -- Ready-Made Millionaire -- that includes a 2X ETF in its real-money lineup.
Make no mistake: The inclusion of this high-octane ETF is far from a market-timing bet. Instead, at the margins of our Ready-Made portfolio, we were able to essentially double up on our exposure to an area of the market that, as I detail below, looks very attractively valued right now.
While I believe that it’s possible to use leveraged ETFs responsibly (i.e., for intelligent asset allocation purposes and opportunistic valuation plays), I think 3X ETFs court a disaster of portfolio-crushing proportions. Instead, if you’ve got a leverage itch to scratch, stick with the 2X flavor -- which are revved up enough -- and then use them only in small, judicious doses.
Throw it in reverse?
By the way, that goes double for amped-up short vehicles. (Alas, they're readily available, too.)
The market’s long-term trajectory is "up," after all. While short ETFs can be convenient tools for reducing your net equity exposure without racking up a nasty capital-gains tax bill, doubling down on a short bet strikes me as the investing version of Evel Knievel's infamous Snake River Canyon gambit. That’s a long way to fall, daredevil.
Better by far to keep your short bets modest; again, use them for smart asset allocation and tax efficiency. Making bets on the short-term direction of the market -- as the last 12 erratic months have made clear -- is a loser’s game. Indulging in leverage to do so means doubling down on danger.
So why have I invested The Motley Fool's money in this 2X ETF? For one thing, it includes Activision Blizzard
That's also true of Helmerich & Payne
In other words, this leveraged ETF enables me to double my exposure to a segment of the market I'd be thin on otherwise -- and it does so by investing in companies I believe in.
The Foolish bottom line
If you've been looking for wealth in all the wrong places, click here to learn more about Ready-Made Millionaire and to snag your free copy of The 11-Minute Millionaire. This special report comes packed with information that can help you zero in on just those investments worth building your nest egg around. If you're a busy investor who hates losing money -- and aren't we all? -- you'll want to commit this one to memory.
Shannon Zimmerman runs point on the Fool's Ready-Made Millionaire service. Activision is a Motley Fool Stock Advisor recommendation. Intuitive Surgical is a Rule Breakers pick. You can check out the Fool's strict disclosure policy right here.