My apologies, but I misspoke earlier in the week. The most dangerous, wealth-destroying investment in the world right now isn't cash. It's leveraged exchange-traded funds (ETFs).
By my count, there are at least 174 of these in existence. And on the surface, these ETFs promise to double or triple the movements of the underlying markets they track. I'm here to tell you that they'll do anything but. You see, double- and triple-leveraged ETFs (whether long or short) pack a nasty surprise. It's almost unbelievable, actually. And particularly in this volatile market, theses ETFs are hardwired for losses.
Here's what I mean.
The Nuts and Bolts of Leveraged ETFs
Leveraged ETFs have been around about as long as Hannah Montana (only since 2006). Given such newness, let's first make sure we're all on the same page regarding the general mechanics of how they work.
A normal exchange-traded fund is constructed to mirror the movement of an underlying index. If the index rises 5%, the ETF that's tracking it is supposed to rise 5% (before expenses). And an inverse ETF simply moves in the opposite direction of the index that it's tracking. So if the index drops 5%, the inverse ETF should rise 5%. When you apply leverage, however, these movements are magnified. So if the inverse ETF uses three-times leverage -- and the index falls 5% -- the ETF should rise 15%.
Sounds simple enough in theory, right? Too bad the reality doesn't measure up. Or, as Yogi Berra used to say, "In theory there is no difference between theory and practice. In practice there is."
Leverage? What Leverage?
Consider this: From January to May 15, 2009, the Russell 1000 Financial Services Index fell by 5.9%. So a long ETF using 3x leverage should have dropped by 17.7% (-5.9 x 3 = -17.7%). Instead, it plummeted by 65.6%. And an inverse ETF using three-times leverage should have been up 17.7%. But it sank by 83.4%.
Talk about not getting what you paid for. Pick any other period, and I promise it will yield similarly confounding results. And the worst offenders will always be the ETFs using 3x leverage. The question is: Why?
Two Fatal Flaws of Leveraged ETFs
Just so we're clear, I don't detest all exchange-traded funds. Regular ETFs provide a low-cost way to achieve instant diversification and access markets that aren't readily available. And unlike traditional mutual funds, they provide intraday liquidity. But when it comes to leveraged ETFs, those benefits are completely nullified by two fatal flaws.
Fatal Flaw No. 1: Daily Rebalancing
Leveraged ETFs don't actually buy individual stocks. Instead, they invest in derivatives. And these derivatives require daily rebalancing in order to match the rise or fall in the index. Otherwise, the leverage ratio for the ETF will be off-kilter. That means leveraged ETFs can only be counted on to perform (as promised) for a single day.
In other words, they're for day traders only -- not investors. But this distinction isn't being communicated clearly to investors. As a result, the SEC actually felt the need to issue its own warning about the confusion surrounding leveraged ETFs.
Fatal Flaw No. 2: The "Dark Magic" of Compounding
For years, we've been wooed by the magic of compounding returns. If you're 18 years old and invest $2,000 per year for three years (and not a penny more after that), they say you'll end up a millionaire if you simply leave it invested and let compounding work its magic.
But when it comes to leveraged ETFs, compounding often works against us. For example, consider what would happen if a regular ETF drops by 10% one day, then rises by 10% the next. (For simplicity's sake, let's assume the starting value of the index it tracks is 100.)
- Day 1: The ETF would be down 10% to $90.
- Day 2: It would rise by 10% to reach an ending value of $99.
Total Return: -1%
Now let's take a look at what happens with an ETF that seeks double the return of the index (i.e., uses 2x leverage). Again, we'll assume a starting value of $100.
- Day 1: The ETF would be down 20% to $80.
- Day 2: It would rise by 20% to reach an ending value of $96.
Total Return: -4% (when it should actually be down only 2%)
If we ratchet up the leverage to 3x and extend the holding period, it magnifies the negative impact of compounding. Toss in some market volatility, which we're experiencing now, and this tracking error gets even worse.
Bottom line: Beneath a simple exterior -- and the allure of a novel hedging strategy -- there are considerable complexities and risks associated with leveraged ETFs. Unless you're a day trader, with an uncanny ability to predict every jot and tittle of the market, avoid leveraged ETFs like the plague. Heck, even if you could pull off such a feat, the transaction costs would eat your portfolio alive.
So the best bet is to simply avoid leveraged ETFs altogether.