Leveraged ETFs; not for the faint hearted

The appeal of investing in a leveraged Exchange Trades Fund or an Exchange Traded Note (from here ETF) is simple; the leveraged fund increases the exposure and impact of the underlying investment. For example a leveraged ETF based on oil may attempt to double or triple the return of a benchmark oil index on a daily basis.

The first leveraged ETFs were launched by ProShares in 2006. These were referred to as ‘Ultra ProShares’ and still exist to this day. These ultra ETFs were designed to double the daily performance of the underlying index they track.

Since 2006 various providers continue to roll our more leveraged options for investors. A quick Google search provides a list of leveraged ETFs that track equity indices, commodities, currencies and interest rates.

Purchasing a leveraged ETF is as simple as issuing a buy order to your broker, similar to buying an equity. It is much simpler than using complex options, futures and margin trading. For those who have access to a low cost trading platform, leveraged ETF’s can be a tool for intraday trading.

The performance of these ETF’s over the short-term is generally accurate and in general reflects the objectives set out in the prospectus. However, it is also fair to say these products long-term performance is not as accurate. The difference in accuracy between the short-term and the long-term is partly due to a concept called decay.

Basically if an investment price at 100 loses 10 percent, it requires an 11.11 percent gain to return to 100. This mathematical law often leads to disappointment for long term investors in leveraged ETFs.

Leveraged ETFs are thus best suited for investors who are using a short-term trading strategy. They are also helpful for investors who would like to gain an exposure to a specific index, but do not have enough capital.

Using a top down approach one may filter the most attractive sectors and invest in a leveraged ETF that give exposure to that sector. Thus investors may eliminate the risk associated with investing in a single asset and leverage the risk on the whole market.

On the downside, an investor has to keep in mind that any losses will be multiplied, and as already mentioned, long term investors should stay away. Without any doubt leveraged ETFs are not for everyone but may be a useful vehicle for the right strategy and for an investor who is diligent.