The appeal of exchange-traded funds (ETFs) is simple: They mix the diversification benefits of mutual funds with the ability to trade on an intraday basis. There are now thousands of ETFs to choose from and more are being added on a regular basis.

Tutorial: ETF Investing

The purpose of a leveraged ETF is to increase the exposure to and impact from the underlying index or investments in the ETF. For example, the leveraged ETF may attempt to double the return of an index on a daily basis. (To learn more about indexes, see The ABCs Of Stock Indexes and Index Investing.)

Leveraged ETFs provide another tool for investors to access leverage in the financial markets. And because purchasing an ETF is as simple as issuing a buy order through your trading account, it is a much simpler process for most than using options, futures and trading on margin. In this article, we'll show you some key considerations to watch out for when purchasing leveraged ETFs.

In June 2006, ProShares introduced the first wave of leveraged ETFs, referred to by the company as "Ultra ProShares." The ultra ETFs were designed to double the daily performance of the underlying indexes they tracks. For example, the ProShares Ultra Dow 30 ETF (NYSEARCA:DDM) is structured to gain 2% when the Dow Jones Industrial Average gains 1%.

More companies such as Direxion followed suit and according to data from Morningstar there are now more than 170 leveraged ETFs with over $30 billion in assets under management at the end of September, 2016. These funds use a number of instruments to hold positions across asset classes including equity, debt, commodities and derivatives. These investments can also be highly concentrated on sectors, for example ProShares UltraPro Nasdaq Biotechnology (UBIO,) or focused on certain geographies like Direxion Daily FTSE China Bull 3X ETF (NYSEARCA:YINN).

Do They Deliver?

The idea behind such funds is to take advantage of quick day-to-day movements in different financial markets. ProShares Ultra S&P 500 (NYSEARCA:SSO) was launched in 2006 with the aim of doubling the returns of the underlying S&P 500. The prospectus of the fund clearly lays out that the intention is to double the daily return and not over the long term. In fact it goes on to say that for periods longer than a single day, the fund could lose money if the underlying index remains flat or even sometimes when it rises. For example, one a day in October 2016 when the S&P returned 0.48%, the fund gave back 0.82%. A similar trend exists for the performance over 1 week, but anything longer a disparity emerges.

On a daily basis, the return of the ultra ETFs has been fairly accurate, but over the long term there are some issues.

In theory, a leveraged ETF that returns twice that of the S&P 500 would have generated annual returns of over 13% over the last ten years. The performance of ProShares Ultra S&P 500 fund has been a far cry from its target. Let alone double, the fund's 10 year return as on October 25th, 2016 at 6.73% struggled to even match the S&P's 6.83% over the same period.

This divergence can be explained by a short example. Assume the Nasdaq falls 2% in one day and rebounds with a 1% gain the following session. The index will have a two-day loss of 1.02%. An ETF that gives investors double the index will result in a 2.08% loss after two days. If the ETF returned exactly twice the index, the return should be -2.04%. Granted the difference is small in the example, but it can increase drastically over time with compounding. If a stock falls 2%, it must rally 2.04% to get back to even. Over time, this takes a toll on performance.

Regulators SEC and FINRA in a 2009 alert clarifying this for individual investors said, "Some investors might invest in these ETFs with the expectation that the ETFs may meet their stated daily performance objectives over the long term as well. Investors should be aware that performance of these ETFs over a period longer than one day can differ significantly from their stated daily performance objectives."

Keep Costs in Mind

While an investor shells out about 0.9% on average annual management fees for such funds, there's another factor that could impact the actual returns. There are transaction costs associated with every time the fund buys or sells securities, and taxes if these transactions are taxable. These costs are typically not accounted for in the annual expenses but are reflected in the fund's performance. Funds that rely on daily rebalancing to make the most of the movements in the market would typically have higher portfolio turnover or more transactions. The ProShares Ultra S&P 500 in its latest prospectus reveals a 7% portfolio turnover of the average value of its fund during the most recent fiscal year.

Strategic Leveraging

Leveraged ETFs are typically best used by investors who are using a short-term trading strategy. Traders who are seeking to capitalize on daily movements - either in the market or in a specific sector - are able to use the ultra ETFs to gain leverage. Because the ultra ETFs give short-term traders the leverage needed on a daily basis without the negative compounding error, most will get in and out within a day.

The ultra ETFs can also be helpful to investors who would like to gain overexposure to a specific sector or index, but do not have the required capital. For example, suppose that an investor is 95% invested in a diversified allocation, but is lacking exposure to the utility sector. The investor's goal is to invest 10% of his or her portfolio into semiconductors; however, with only 5% in cash it might appear impossible. The investor can use the 5% cash available to purchase a leveraged ETF that invests in semiconductors such as Direxion Daily Semicondct Bear 3X ETF (SOXS) and, in reality, give the portfolio a 10% allocation to the sector. (To learn more about asset allocation, see Five Things To Know About Asset Allocation, Choose Your Own Asset Allocation Adventure and Asset Allocation Strategies.)

Wrapping It Up
To recap, the advantages of the leveraged ETFs are:

  • They offer a way to use leverage without using options or margin.
  • They are available in retirement accounts.
  • They are a great trading tool for short-term traders.

The negatives associated with leveraged ETFs include:

  • Aims to generate daily returns not long-term performance
  • The impact of negative compounding can result in long-term inaccuracy.
  • High portfolio turnover could dampen returns further
  • Leveraged ETFs are a high-risk investment that could be dangerous to the uneducated investor

Overall, leveraged ETFs may be useful only to savvy investors, all others should perhaps stay away or do their due diligence before investing.

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