Leveraged ETFs are one of the hottest new fund ideas around. But the big wins aren't for everybody -- leveraged ETFs can pull your portfolio into the red while long-term investors wait patiently for their winnings. Here's what you need to know.
Leveraged ETFs 101
Leveraged ETFs are the most exciting exchange-traded funds around. At their core, they are designed to double or triple (or more) the returns of a regular ETF on a daily basis. They're able to award investors more bang for their buck by using debt and derivatives, resetting the clock every singly trading day. These are, of course, tricks any individual investor could pull on their own, but leveraged ETFs wrap them up in a pretty package.
But while investors can earn exponentially higher earnings, leveraged ETFs work both ways. When these funds go up, investors applaud. But when they go down, they go down by the same degree. That means that a bad day for the S&P 500 (SNPINDEX:^GSPC)
Go short or go home
There are a lot of stocks and strategies that aren't good for long-term investors, but leveraged ETFs are especially bad. That's because they're designed for investors to get in and out in a single day, a trading timeline that lends itself to speculative technical analysis over strategic fundamental investments.
Consider this scenario. On Monday, you decide to invest $1,000 in ProShares UltraPro S&P500. It's a bull day for Mr. Market and the S&P 500 goes up 5%. Since you've opted for a three-times-leveraged ETF, that leaves you with 15% gains and $1,150 worth of ProShares shares at the end of the trading day.
You're happy with Monday, so you decide to stick around for Tuesday. But the bears close in, dropping the S&P 500 back down 5%. For you, that equates to a 15% loss on your $1,150 worth of shares, or $172.50. So while the S&P 500's drop leaves normal index investors with a $2.50 overall loss Monday morning, your leveraged ETF has left you $22.50 poorer with just $977.50 of equity.
Not only can leveraged ETFs leave you with multi-day losses -- their expense ratios will eat into your assets. ETFs are often touted for their ultra-low expense ratios. While mutual funds skim full percentage points of the top, ETFs are known for their one-tenth of a percentage point costs. But the ProShares UltraPro S&P500 starts to look a lot more like a mutual fund when you consider its 0.95% expense ratio, a far cry from the ETF ratios investors have learned to love.
When leveraged ETFs win
Leveraged ETFs haven't gained acclaim for nothing. The S&P 500 has enjoyed more up than down since the trough of the Great Recession, multiplying leveraged ETF earnings accordingly. From its inception in June 2009 to April 2015, the ProShares UltraPro S&P500 earned 49.31% at an annualized rate, compared to just 18.07% for the S&P 500. But if the S&P 500 had performed inversely during the same period, leveraged investors would be looking at a similarly oversized loss compared to the S&P 500's.
Don't leverage your long-term
Leveraged ETFs may tempt some technical investors, but their outsized risk doesn't correspond to any reality-based upside in return. For long-term investors looking for diversity, non-leveraged ETFs provide a low-expense alternative with no worries over making the right day trade.
Justin Loiseau has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. 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 Motley Fool has a disclosure policy.