With the current fragile market inspiring more and more investors to make directional bets on the performance of the market, a popular class of exchange traded funds has attracted attention. Unfortunately, the growing popularity of leveraged ETFs is coming at a painful price.

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A Primer
The popularity of leveraged ETFs is easy to explain. They allow the small investor to make big directional bets on a market or industry without having to assume leverage. Investors can now make leveraged bets without having to open margin accounts. Unfortunately, many investors have been burned badly by investing in these instruments even after making the correct market call.

Consider a very popular EFT, the UltraShort S&P 500 ProShares (NYSE:SDS), which is designed to deliver daily investment results which equal twice the inverse of the daily performance of the S&P 500. In other words, the SDS sounds a like a great way to hedge against a market sell-off. If the S&P declines 2% one day, the SDS will go up by 4%. (For more, see Inverse ETFs Can Lift A Falling Portfolio.)

A Painful Lesson
A closer examination reveals this is not the case. In 2009, the S&P 500 began at 903 and today sits at about 880 or a decline of about 2%. One would think that the SDS should be up around 4%. Unfortunately, a chart reveals that the SDS is actually down 10% this year. Even the Ultra S&P 500 ProShares (NYSE:SSO) which is supposed to deliver twice the index result - and thus expected to be down 4% - is down 14% this year. (For more, see Five Ways To Find A Winning ETF.)

Are these levered ETFs misleading investors? In actuality, the instruments are being completely candid with investors. The stated goal of the levered ETFs is to produce daily investment results based on the long or short strategy of the fund. Some basic math provides clarity.

If the S&P 500 declines 15% one day, to get back to par will require a gain of approximately 18%. A 15% decline for the S&P will result in a 30% decline in the SSO ETF. A 30% decline requires a 43% return to get back to even. But since the SSO mimics the S&P 500, when the S&P gets back to even by going up 18%, the SSO has only appreciated by 36%, not the required 43%.

Offer Good for a Limited Time
You can see the trouble these ETFs can cause when they are misunderstood and used inappropriately. By definition, they are designed for short-term directional bets. From January until March when the market headed south fast, the SDS was up nearly 100%. Similarly, the UltraShort Financials ProShares (NYSE: SKF) and Ultra Financials ProShares (NYSE: UYG) have each staged triple-digit returns over short periods this year. But year to date, both are off over 40%.

The Bottom Line
Unfortunately for investors, the ETFs are doing exactly what they are supposed to be doing on a daily basis but as long-term leverage instruments they are deadly. Understand the basic simple mechanics and you will be better off. (For further reading, see Dissecting Leveraged ETF Returns and Rebound Quickly With Leveraged ETFs.)

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