The Dangers of Leveraged ETFs

By: Jilly Pretzel

Leveraged ETFs sounds like an investor’s dream: an easy way to get 2, 3, or even 4X returns on the market. But leveraged ETFs (or LETFs) can be very risky. If the market dips, that means 2 or 3 (or even 4) times the amount of losses. It’s important to know that LETFs are best for short-term investments made by experienced traders.

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So, What Exactly is an LETF?

If you’re an investor (or are just starting to look into investing) you’ve probably heard of ETFs. They’re a bit like a mutual fund in that they represent a professionally managed collection of stocks or bonds. However, ETFs are passively managed and are usually considered to be a bit less expensive than mutual funds. It’s an investment that you can stay in for years while you expect your investments grow (albeit sometimes slowly) over a long period of time.

So, what does it mean when an ETF is leveraged? LETFs, are funds that use debt and financial derivatives to increase the returns on an underlying index. So, with that leverage, LETFs rise and fall by 2X or maybe 3X (depending on the LETF ratio) and therefore carry higher risks than a traditional ETF. While they may be available for most indexes (like the Dow Jones and Nasdaq), they’re not necessarily right for every investor. In fact, if you’re the kind of investor who is interested in the safety of ETFs, the fast-passed, high-risk world of LETFs probably isn’t for you…or your portfolio.

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You Might Be Asking: Why Are LETFs Risky?

Because of the high-risk, high cost structure of LETFs, they can be very dangerous for the long-term investor. In fact, they can be pretty risky for any investor. With the leveraged ratio you can gain, and lose, money fast. You simply never know what the markets are going to do.

While you might invest in a regular ETF for years and years, people usually only invest in LETFs for a day (or just a few hours). It’s not something you want to stick with for a long time because while LETFs could mean high rewards on the short term, they almost always show loss in the long run.

But, perhaps you’re saying that you’re up for the challenge. Maybe you’re thinking, that with high risk may come high reward, but the troubles don’t end with the gamble associated with doubling down.

While high expense ratios are at least transparent, some investors don’t realize that LETFs need to be rebalanced daily and volatility ends up costing them. Of course, this probably sounds strange; volatility is usually a good thing in the market. It’s movement and possibly growth. But with LETFs, the compounding effects of daily returns throw off the math so you could be losing more than you think, faster.

For example, if the market goes down 5 percent and you have a 2X LETF, you’ll be down 10%. So, if you started at $100, you’d now be at $90, rather than $95 like a non-leveraged ETF investor would be at. Of course, you’re bound to expect this: you win some, you lose some.

But then, on the second day, if your LETF goes up 5 percent (that’s the “win some”) you won’t be getting back up to where you started (of course, neither would a non-leveraged ETF investor because 5 percent of $100 is more than 5 percent of $95, but with your LETF, it would take a much bigger increase to get you back up there. Meanwhile, there’s no guarantee that the investment will go up on that second day, or even the third or forth. That’s why LETFs generally lose money over time.

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But Wait, There's More...

Because with all that risky volatility, an LETF must constantly be corrected (usually by borrowing more or less) and keeping that ratio constant comes with a lot of fees.

So, with the risk of a fast-paced investment, the volatility, and the additional fees, LETFs are far from the smart, safe investment ETFs have been known to be. If you’re looking for a long-term investment to add to your portfolio, you might consider an ETF or mutual fund. Don’t, if you’re a new investor, don’t let yourself be tempted by the promise of major profits because LETFs, this so-called investor’s dream, can turn into a nightmare. And can do so at double or triple the speed.