Are Leveraged ETFs Just Double-or-Nothing Bets?

Volatility makes leveraged ETFs unsuitable for most investors.

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But look what happens to its total position: It now has $102 million in assets and $100 million in debt, for a total of $202 million. To maintain a 200 percent leverage ratio, it needs either to borrow an additional $2 million (to maintain total exposure of $204 million) or it can take the $2 million in Day 1 gains off the table. In either case, it would be "rebalancing" to maintain its promised leverage ratio. If it did not rebalance every day, the changing portfolio value would quickly make it impossible to predict returns relative the underlying index.

Exacerbating the rebalancing problem, there is a powerful headwind created by simple math. When a stock falls 10 percent, you need an 11 percent gain to make up the loss. Likewise, you need a 25 percent gain to make up for a 20 percent decline. The S&P 500 might indeed gain 10 percent over the next three months, but along the way it will most likely slip sharply on some trading days—1.5 percent here, 2 percent there. Over the three months, those declines will eat up a lot of the gains.

And that's where the naïve investor gets nailed. "You can make the bet correctly—the S&P was actually up 10 percent," says Nadig of IndexUniverse. "But if the way it got there was on a bumpy road, these daily-reset products will kill you."

The only way you're likely to double the performance of the S&P over the three months with your 200 percent leveraged fund is if the index rises in something close to a straight line. But straight lines are not very common in any universe where most of us are likely to invest, and most of us don't have the wherewithal to rebalance our portfolios every day.

Even the folks at Direxion, a major issuer of leveraged ETFs, agree that they're not for most investors. "If you're someone with a long-term buy-and-hold objective, they're definitely not suited for you," says Andy O'Rourke, Direxion's chief marketing officer. "These are trading vehicles. They're for people trying to trade the market on a short-term basis."

There's another hurdle as well: taxes. "If the end investor wants to use [a leveraged ETF] appropriately, they have to trade every single day," says Paul Justice, Morningstar's director of ETF research for North America. "That means any of the gains you capture are going to be taxed under short-term capital gains." While long-term capital gains are taxed at 15 percent, short-term trading gains can be taxed at a hefty 35 percent—a formidable obstacle for even the most savvy trader.