Leveraged ETFs promise the benefits of fast profits with little concern toward commonsense investing risks. In fact, a good friend and colleague of mine recently wrote an article titled “When Do Leveraged ETFs Make Sense?”, arguing 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 gladly take the other side of that debate.
There are a number of important facts you need to know before deciding to invest in leveraged ETFs. 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.
Leveraged ETFs 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 six-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 carry expense ratios between 0.9% and 1%. That is considerably higher than the majority of passive index ETFs with expense ratios that fall below 0.5%.
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. But 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.
Only highly disciplined traders with a stop-loss or other risk management philosophy should even consider this style of fund.
If you are looking to make a bold directional bet on the market, you may be better served in a single beta ETF with a larger allocation size rather than a small slice using a leveraged fund.
Bottom Line
Successful use of leveraged ETFs will require quick entry and exit points along with intestinal fortitude to weather any speed bumps along the way.
Much of investing is fighting the psychological pull of 20-20 hindsight. When you get it right, you wish you had bet more or used leveraged to magnify your returns. Conversely, if you are wrong, you wish you had seen the pitfalls ahead of time and minimized your exposure.
I will admit that I am a conservative investor by nature and would rather take a slow and steady approach to the market in lieu of assuming an inordinate amount of risk. Having that self-introspection allows me to select investments that are appropriate for my goals and align with my risk tolerance.
David Fabian is Managing Partner and Chief Operations Officer of FMD Capital Management. To get more investor insights from FMD Capital, visit their blog.
