Leveraged exchange-traded funds (ETFs) seek to multiply and sometimes invert the daily return of an underlying index or asset. There are plenty of leveraged ETFs available with varying objectives and degrees of leverage, but these securities have certain risks and disadvantages that investors should be aware of.
How leveraged ETFs work
Exchange-traded funds are essentially mutual funds that trade on a major stock exchange. Many ETFs allow investors to own all of the stocks in an index, such as the S&P 500, while others are actively managed.
Leveraged ETFs use debt and/or derivatives to generate double or triple the daily performance of a certain index or asset class. Leveraged ETFs typically amplify daily returns by either two or three times, and can be either long (bull) or short (bear) ETFs.
As a basic example, the ProShares UltraPro Short S&P 500 ETF (NYSEMKT: SPXU) is an inverse triple-leveraged ETF that is designed to return three times the inverse of the S&P 500 index. In other words, if the S&P 500 drops by 2% tomorrow, this fund should rise by roughly 6%. If the index rises by 1%, this fund should drop by about 3%.
Dangers of leveraged ETF investing
Leveraged ETFs certainly have their purpose for short-term investing. As an example, an triple-leveraged ETF can be used as a hedge to protect a short position. However, long-term investors should be cautious of leveraged ETFs.
For one thing, they tend to charge higher-than-average expense ratios. As a quick comparison, the ProShares UltraPro S&P 500 (NYSEMKT: UPRO) ETF, which is a triple-leveraged S&P 500 ETF, has an expense ratio of 0.94%. On the other hand, the Vanguard S&P 500 ETF (NYSEMKT: VOO) is a non-leveraged S&P 500 index fund that charges just 0.04%. However, the fees are the least of long-term leveraged ETF investors' worries.
Sure, when things are going great, leveraged ETFs look like excellent investments. Through the first half of 2017, the S&P 500 has returned just over 10% (including dividends) and the triple-leveraged ETF I mentioned has returned nearly 30%. No surprises yet.
However, consider what happens when the market turns sour. As a simplified example, let's say that the S&P 500 drops by 20%. A triple-leveraged ETF tracking the index could be expected to fall by roughly 60%.
Here's the key point: With a non-leveraged ETF, the index would have to rise by 25% to bring you back to even, but with the leveraged ETF, you would need the fund to rise by 150% just to recoup your losses. Considering the triple leverage, this means that the S&P 500 would now need to rise by 50% -- twice that of the non-leveraged version -- just to break even. In a nutshell, the mathematics work against you when the leveraged ETF's index doesn't move favorably. Unless the index goes straight up forever, there is a clear negative bias over time.
The Foolish bottom line
While leveraged ETFs certainly serve a purpose, they make lousy long-term investments. If you want to invest in an index like the S&P 500 for the long run, you're far better off simply purchasing a basic non-leveraged index fund. You won't get rich quick, but you also won't go broke quickly if the investment doesn't go your way.
This article is part of The Motley Fool's Knowledge Center, which was created based on the collected wisdom of a fantastic community of investors. We'd love to hear your questions, thoughts, and opinions on the Knowledge Center in general or this page in particular. Your input will help us help the world invest, better! Email us at email@example.com. Thanks -- and Fool on!
The Motley Fool has a disclosure policy.