The Danger of Leveraged ETFs (ZT)

There is a tremendous misconception that leveraged (double, triple, long or short) ETFs are to be used as long-term investments. On the surface they make a lot of sense. You want to hedge your stock portfolio, for instance, so you buy a double short ETF of the market like SDS (double short of S&P 500) or QID (double short of Nasdaq 100) and for each 1% decline of the market you make 2%. It does sound like a great deal.

Leveraged ETFs have been sold as panacea to this market volatility, but a panacea they are not. If used as investment (not trading) vehicles they may cause a lot of harm to your portfolio even if you were “right” on their use. They should not be used as a long term investment, but only for short-term trading (i.e. days not months).

Daily compounding (recalculation) will cause their returns to deviate substantially from the underlying index. The math is too complex and too boring (here is an article by Morningstar that explains this well), but instead let me demonstrate by this very real example (click here to see the chart ). Let suppose that six months ago you had a great insight that financial stocks will decline. You figured to get bigger bang for the buck you’ll buy a double short of Dow Jones Financial Index (a simple plain vanilla long ETF for this index goes by symbol IYF). The index and thus IYF declined almost 20% in six months thus you’d expect your double short (SKF) would be up about 40%. However, if you look at the chart below you’ll see that it declined almost 60% instead, as much as double long ETF (UYG) of the same underlying index.

Note that over the short term (days) these ETFs seem to work. This is one of those investments where you have to make sure that you nail the timing perfectly, otherwise you are screwed.

In the long run, all the 2X, 3X ETF will go to near zero, because the underlying instrument is options, not stocks, there is time decay.

To me, the gist of this article is about the dangers of leveraged ANYTHING; hedge funds ETFs, real estate, you name it.