Beware The Allure Of Leveraged ETFs

leverage-decayDavid Fabian: Leveraged ETFs promise the benefits of fast profits with little concern towards common-sense investing risks. In fact, a good friend and colleague of mine recently wrote an article titled When Do Leveraged ETFs Make Sense? The argument is that for a small portion of your portfolio, these funds can make you a quick buck as long as you are willing to bet boldly.

I will take the other side of that debate and point out that there are a number of important facts you need to know before deciding to invest in these vehicles. Like most things in life – there is no free lunch when it comes to assuming a stated level of risk for a consummate expected reward.

These products have become increasingly popular among retail investors in addition to institutional traders. The ProShares UltraShort 20+ Year Treasury Bond ETF (NYSEARCA:TBT) is the largest leveraged ETF by size with over $3.1 billion in total assets. This fund tracks two times the daily inverse price of a basket of long-term Treasury bonds. It’s essentially double short the iShares 20+ Year Treasury Bond ETF (NYSEARCA:TLT).

There are also countless leveraged ETFs that are both long and short domestic and international stocks, commodities, and other fixed-income indexes. Before you consider using these tools in your portfolio, take a step back and ponder the following points:

Don’t Overstay Your Welcome

The most important disclaimer that all leveraged ETFs employ is that the fund is designed to mirror the stated price action of the underlying index for a single day. Each day the leverage is reset and the process starts all over again. This can ultimately lead to issues with the returns of a single beta index not tracking consistently with a leveraged ETF over long periods of time. In the above example, you can’t expect that a 10% loss in TLT over a 6-month period will result in a perfect gain of 20% in TBT.

The magnification of price action in both directions can provide a drag on the performance of a leveraged ETF and erode its tracking efficiency over time. These vehicles are designed to capitalize on very short-term moves in the market rather than as long-term holding vehicles.

High Fees

Another important consideration of leveraged ETFs is the high fees that they carry. Many of the leveraged funds from ProShares and Direxion Shares carry expense ratios between 0.90% and 1.00%. That is considerably higher than the majority of passive index ETFs with expense ratios that fall below 0.50%.

If you are just looking to trade these vehicles for a week, then you likely aren’t concerned about those embedded expenses. Nevertheless, they become an important part of your total investment outcome if they are used frequently.

High Risk

Most investors are happy with a 10% return on their portfolio in any given year. Yet leveraged ETFs can produce those types of returns in days (if not hours). That works well if you have chosen the right side of the market to be on. However, the consequences of a misstep using a leveraged ETF can quickly erode your capital and make you wish you had never invested to begin with.

(…)Click here to continue reading the original article: Beware The Allure Of Leveraged ETFs [iShares Barclays 20+ Yr Treas.Bond (ETF), ProShares UltraShort Lehman 20+ Yr(ETF)]
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