Are Leveraged ETFs Just Double-or-Nothing Bets?

Volatility makes leveraged ETFs unsuitable for most investors.

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Just as the rise of ETFs in the past 20 years has made it easier for retail investors to target particular asset classes, the explosion of leveraged ETFs since 2006 has allowed them to get, well, leverage, on those assets. Leverage, of course, is the art of using a little of one's own money (along with borrowed money and maybe some exotic derivatives) to amplify returns on an investment.

Thanks to issuers like Direxion and ProShares, you can find leveraged ETFs for just about any index or asset class, ranging from the popular ProShares Ultra S&P 500 (symbol: SSO) to more obscure offerings like ProShares Ultra DJ-UBS Natural Gas (BOIL), which promises to double the performance of an index of natural gas futures. Leveraged ETFs, just like the unleveraged type, offer the benefit of intraday trading and charge annual expenses that are usually lower than mutual funds.

[Research leveraged ETFs at U.S. News.]

Among the more popular leveraged ETFs these days are those that bet on banks, like Direxion's Financial Bull 3x Shares (FAS), which seeks to generate—before fees and expenses —returns equal to 300 percent of any one day's gain on the Russell 1000 Financial Services Index. If the index rises 2 percent, FAS should rise 6 percent. Direxion's Financial Bear 3X Shares, an "inverse" ETF, is supposed to do likewise when the index declines.

Should the average investor be dabbling in this sort of thing? Advisers generally say no. If leveraged ETFs are good for anything, they say, it's only as a quick in-and-out by the sort of people who stare at a Bloomberg terminal all day. In other words, they're for the sophisticated investor looking to speculate or hedge, not someone investing long-term for a secure retirement.

At first glance, that might seem counterintuitive. After all, if you're confident enough to invest in something because you think the value will rise over, say, the next three months, why wouldn't you want to get some leverage on that investment? Wouldn't not leveraging be leaving money on the table? Look what happened to FAS during the three-month period starting in December 2010, when financial stocks staged a strong recovery: While the Russell 1000 was up about 9 percent over the period, FAS was up 25 percent. Exactly what one should have expected, right?

Not exactly. There are two kinds of risk associated with leveraged ETFs, says Dave Nadig, director of research for IndexUniverse. One is "beta" risk, the sheer volatility you encounter when holding a highly leveraged investment: Leverage, of course, amplifies losses just as it does gains.

[See How Safe Is Your Safe Money?]

The other risk is what Nadig calls "expectational" risk: the difference between what you expect to get if you take a descriptor like "three times leveraged" at face value, and what these funds actually deliver in the real world of volatile share prices.

It's that second risk that matters most. True, if the underlying index of a triple-leveraged ETF rose steadily for some period with little or no downward correction, the ETF would substantially outperform the index. Indeed, it would probably end up more than 300 percent ahead, because of the way gains compound on the way up.

In practice, though, the longer-term performance of leveraged ETFs has little correlation to the performance of the underlying index, so the advertised leverage ratio is not meant to apply for as long as you happen to own the ETF. It applies only to a single day's performance of the index. If the index rises 1 percent on Day 1, the triple-leveraged ETF should rise 3 percent. That does not mean that if the index rises 10 percent over the next month, you can expect the ETF shares to gain 30 percent. Under normal market conditions, you'd almost certainly get a lot less.

Here's how it works. Imagine there's a fund that aims to double the performance of the S&P 500. It does that by investing, say, $100 million of shareholders' money and (in a simplified example) borrowing another $100 million, for $200 million in total exposure. If the index rises 1 percent on Day 1, the fund will have a 2 percent gain (1 percent of $200 million) before expenses.