The panelists are three SA contributor portfolio managers who use ETFs in client portfolios and write actively on new developments in the field of exchange traded funds. Here are the panelists, their credentials and a preliminary writeup from each of them with their views on leveraged ETFs:

1) How, if at all, do you use leveraged ETFs in your own portfolios?

At the ETF Digest, we’ve recently launched an all leveraged ETF program for Dave’s Special Portfolio. In it we’ve broken down the current group to a dozen that are currently popular based on performance and liquidity. At the same time, we keep another two dozen or so in reserve to bring out as interest and liquidity build. Our approach is very short-term, with holding periods of a day or so if unsuccessful, to no more than two weeks if successful.

I have used ProShares Ultra Short S&P 500 (SDS) intermittently to hedge client portfolios. The weightings are always small -- initiating positions at 2-3% of the portfolio.

I prefer using funds covering broad indexes. The daily compounding of the sector products can be very difficult to anticipate and can be very ineffective for hedging purposes. Likewise with the 3X products. The variability along these lines with SDS is, to me, acceptable.

When we listen to the news, we mostly hear about large, brand-name companies. However, mid-sized companies and related ETFs have shown some decent gains as the economy rights itself.

According to Will McClatchy for ETFZone, overweighting or underweighting mid-caps coming out of a bear market can be a good play for an ETF portfolio, depending on the economic conditions, and mid-caps are relatively less volatile than small-caps.

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:

In our last post we looked at non-leveraged ETFs, and below we highlight the best and worst performing leveraged ETFs so far in 2009. Even though the market is trading close to flat year to date, only 27 of the 110 leveraged ETFs that we track are up for the year. The double long technology ETF (ROM) is up the most at 36.37%, followed by the double long semiconductor ETF (USD), the double long QQQs (QLD), and the double short long-term Treasury ETF (TBT). The second best performing double short ETF is the Japanese Yen (YCS).

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Below we highlight the best and worst performing leveraged and/or inverse ETFs since the S&P 500 made its recent bottom on November 20th. With the S&P 500 up more than 20% since November 20th, there's no surprise that the entire list of the biggest gainers is made up of long ETFs, while all ETFs in the list of losers are inverse (short). As shown, the 3x smallcap ETF (TNA) is up the most since 11/20 at 82%, followed by 2x basic materials (UYM), 2x telecom (LTL), and 2x midcap growth (UKW).

On the downside, the 2x inverse real estate ETF (SRS) has declined the most at -78%. SRS is followed by 3x inverse financials (FAZ), 3x inverse smallcap (TZA), and 2x inverse China (FXP).

A lot of authors on Seeking Alpha have noted that levered ETFs don’t behave as some investors intended to due to compounding effects. The levered or inverse products do what they say over a period of a single day, but not over a longer time-period. Recent examples are the post by Paul Kedrosky, where both levered bullish and bearish energy ETFs were negative simultaneously and another post by Matthew McCall, where he noted both a financials ETF and a 2x inverse financial ETF lost over the same period.

To understand better, assume the ETF asset follows a Geometric Brownian Motion (the same assumption used to derive Black-Scholes formula for options). The assumption is not perfect, but not far from reality.

I am a skeptic on leveraged ETFs in one way. My view is that the more levered they get, the less likely they are to replicate the behavior of their index, however levered.

To get high amounts of leverage, they must rely on futures, options, swaps, and options on swaps, and the higher the amount of leverage they attempt to replicate, the greater the amount of slippage they will experience versus their multiplied index. There is also slippage from rolling futures from month to month.

Market participants know that the ProShares Short and UltraShort ETFs have become wildly popular.  These ETFs allow investors with long-only accounts to easily bet against the market or hedge their bets.  The ProShares Ultra ETFs provide either double or double the inverse of the daily returns of the asset classes they track.  In the current market environment, the UltraShort ETFs have been huge winners.

For those interested, below we highlight all of the ETFs currently offered by ProShares.  We also include the year-to-date performance of each one, along with its current percentage from its 50-day moving average (to measure overbought/oversold levels).  As shown, the Ultrashort Financial ETF (SKF) is up a whopping 67% year to date, as financial firms have fallen across the board.  SKF is trailed by the Ultrashort Semiconductors (SSG), Ultrashort Russell 1,000 Value (SJF), and Ultrashort Dow30 (DXD) as far as year-to-date performance is concerned.

ProShares has a diversified lineup of ETFs that allows investors to adopt various strategies based on individual sectors, market-cap, desire to be long or short, etc.

Of the 64 ETFs currently offered, it is clear that some are more popular than others. This popularity is translated into trading volume.

Warren Buffett, John Bogle and Jeremy Siegel all recommend it. That is, many superheroes of the investing universe advise the "little guy" to buy-n-hold index funds. And for these heroes... you should hold through thick, thin, down, up and sideways.

In this article, we lay out the case against these products, based upon popular misconceptions of what exactly these ETFs provide, a hidden trap related to leverage, and the poor performance of related funds and of the ETFs themselves.

ProShares Ultra Style ETFs
ProShares Ultra Russell1000 Value ETF (UVG)
ProShares Ultra Russell1000 Growth ETF (UKF)

The leveraged ETFs are: ProShares Ultra QQQ ETF (QLD), ProShares Ultra S&P500 ETF (SSO), ProShares Ultra MidCap400 ETF (MVV), ProShares Ultra Dow30 ETF (DDM), ProShares Ultra Russell2000 ETF (UWM), ProShares Ultra SmallCap600 ETF (SAA), ProShares Ultra Russell1000 Value ETF (UVG), ProShares Ultra Russell1000 Growth ETF (UKF), ProShares Ultra Russell MidCap Value ETF (UVU), ProShares Ultra Russell MidCap Growth ETF (UKW), ProShares Ultra Russell2000 Value ETF (UVT), ProShares Ultra Russell2000 Growth ETF (UKK), ProShares Ultra Basic Materials ETF (UYM), ProShares Ultra Consumer Goods ETF (UGE), ProShares Ultra Consumer Services ETF (UCC), ProShares Ultra Financials ETF (UYG), ProShares Ultra Health Care ETF (RXL), ProShares Ultra Industrials ETF (UXI), ProShares Ultra Oil & Gas ETF (DIG), ProShares Ultra Real Estate ETF (URE), ProShares Ultra Semiconductors ETF (USD), ProShares Ultra Technology ETF (ROM), and the ProShares Ultra Utilities ETF (UPW).

Ultra Russell 1000 Value (UVG)

Ultra Russell 1000 Growth (UKF)

Ultra Russell MidCap Value (UVU)

Ultra Russell MidCap Growth (UKW)

Ultra Russell 2000 Value (UVT)

Ultra Russell 2000 Growth (UKK)

UltraShort Russell 1000 Value (SJF)

UltraShort Russell 1000 Growth (SFK)

UltraShort Russell MidCap Value (SJL)

UltraShort Russell MidCap Growth (SDK)

The new funds provide 200 percent upside (“Ultra”) and 200 percent downside (“UltraShort”) exposure to Russell’s six main style indexes, and are: