With the market apparently on the verge of another freefall, aggressive investors are once more looking at the promise of leveraged ETFs to try to multiply their gains from a big move in the market. Yet 2010 has once again shown how trying to turn leveraged ETFs into a long-term play on an investment trend can turn out very badly -- even if you pick the direction of the market correctly.
The worst kind of market
For those who buy leveraged ETFs, the best possible outcome is for whatever market the ETF tracks to move sharply and quickly in the correct direction. For instance, during the 2008 financial crisis, after Congress passed the bailout bill, those who bet against financial stocks using the ProShares UltraShort Financials
The problem with most leveraged ETFs, though, is that they aren't able to handle markets that zig and zag back and forth. And after 2009's powerful rally that had stocks moving mostly straight up, we're now in exactly the sort of market that really punishes leveraged ETFs. Consider these examples:
- Over the past year, the price of oil has stayed in a fairly narrow range between $65 and $85 per barrel and is roughly unchanged since last summer. But no matter which way you thought oil and gas stocks would move, using leveraged ETFs to invest long-term has been a losing proposition: The bullish ProShares Ultra Oil & Gas
(NYSE: DIG)is down 12% from a year ago, while the bearish ProShares UltraShort Oil & Gas (NYSE: DUG)has lost 13%.
- Financial stocks have been all over the map over the past year, and leveraged ETFs haven't responded well. The ProShares bearish leveraged ETF has lost 14% in the past year, while the bullish ProShares Ultra Financials
(NYSE: UYG)is off 15%. The triple-leveraged Direxion Daily Financial Bull 3x (NYSE: FAS)and Direxion Daily Financial Bear 3x (NYSE: FAZ)pair have done even worse, down 31% and 28% respectively.
- Small-cap stocks have been particularly volatile in both directions. Yet with the Russell 2000 up around 3% in the past 12 months, you might expect better than a 0.3% loss from the double-leveraged ProShares Ultra Russell 2000 (UWM). Meanwhile, the bearish analogue, ProShares UltraShort Russell 200 (TWM), has fallen 25%.
You can't really blame ProShares or any other leveraged ETF provider for these results. They're a natural mathematical consequence of how these ETFs are structured. By focusing on short-term daily returns, these ETF providers have created funds that are completely unsuitable for long-term investors and that lead to the poor results above and many like them.
What's next: Rolling out the bond funds
Now, attention is squarely moving toward the bond market, where leveraged funds are producing some attractive returns. With long-term Treasuries up 16% in the past 12 months, the relatively new ProShares bullish leveraged Treasury fund has risen more than 40% since its inception in January.
Yet here, the choices investors have made tell the story. While the bullish fund had about $13 million in assets as of July 30, the bearish ProShares UltraShort Treasury 20+ Year
With leveraged ETFs, it pays to listen to the disclosures that the ETF companies themselves are now providing, thanks to a little SEC coaxing. The daily reset puts long-term investors in serious danger of losing their money even when they're right about the general direction a particular market moves in.
If you want to bet against stocks, the better move is simply to sell them short yourself. While that's typically not possible in an IRA or other retirement account, taking on leverage is likely to leave you wondering why your good call ended up costing you money.
Some say investors are giving up on stocks, but stock ETF inflows tell a different story. Get the latest scoop from Morgan Housel on how the death of the individual investor has been greatly exaggerated.
Fool contributor Dan Caplinger only likes leverage when it works. He doesn't own shares of the companies mentioned above. Try any of our Foolish newsletters today, free for 30 days. The Fool's disclosure policy never makes you take a risk.