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The craze of exchange-traded funds (ETFs) which employ leverage (the use of borrowed capital to increase the potential return of an investment) has been on a tear over the past year.* It makes sense that speculative investors would toy around with such vehicles given the extreme market volatility we’ve been experiencing of late. Combine that with the high level of conviction certain day traders have about which direction the markets will move in and when, and you can fully appreciate why the trading volume on these ETFs is so high.

Leveraged ‘inverse’ ETFs are part of this craze as well, allowing investors to take bets against sectors of the market which they expect to decline. Just to be clear, these leveraged ETFs are designed principally for experienced investors who engage in market timing. They wouldn’t generally be suitable for an inexperienced investor or somebody who didn’t fully understand the characteristics, including the risks of the product. The financial advisor channel uses leveraged ETFs as well. In my practice their primary use is as a hedging tool to lock in gains or limit losses on certain positions at certain times. The function which they do not serve, and most advisors will agree on this, is as core portfolio holdings. More on that below:

While leveraged ETFs have been getting better at capturing a high percentage of their targeted daily returns (in terms of NAV), they are most valuable in one-directional markets. If the S&P 500 were to bounce up 10%, down 10%, up 10%, down 10%, etc. for a period of months, you’d ultimately lose money holding leveraged ETFs as your core holdings. This would happen to a much lesser extent with ordinary index funds because the long-term erosive quality of leverage wouldn’t apply. It’s the same principal which applies to the stock market when it moves up and down. If the Dow Jones drops from 10,000 to 8,000, that’s a 20% decline. However, for it to rally from 8,000 back to 10,000 is a 25% return.

Investors must understand the risks of daily fluctuation when they buy leveraged and inverse leveraged ETFs. I strongly advise reading the prospectus on these funds—it may wildly change your perception of the product once you read the disclaimers on the use of leverage, the consequences of seeking daily leveraged investment results, and the small population of investors/speculators who these products should really appeal to.

Even given that risk, there are some advisors whom I spoke with in April and May who were convinced the market was going to move higher (as it has at the point I’m writing this article). With this scenario of lower volatility and strong market moves in one direction, the leveraged ETF could prove a valuable investor tool. They can be especially useful in IRA accounts which do not typically allow an investor to short the market or employ leverage.

The bottom line on these: useful tools for speculation if you’re educated about the product and know what you’re doing. If you don’t, watch out below as these funds can zap your account value as fast they can build it up.

Editor's note: This article was updated from the original on 10/15/09 with a change in the third paragraph.

Source: On the Risks of Using Leveraged ETFs