Leveraged ETFs: Why Investors Should Know Their Risks

Leveraged ETFs are alluring in that they offer the potential for quick gains. But they also come with little concern towards common-sense investing risks. Recently, a good friend and colleague of mine wrote an article titled When Do Leveraged ETFs Make Sense?  It’s a good read, and fair analysis. The argument is that for a small portion of your portfolio, these funds can make you a quick buck as long as you are willing to bet boldly.

However, today I would like to take the other side of that debate and point out that there are a number of important facts investors need to know before investing in these vehicles. Like most things in life – there are no guarantees when it comes to assuming a stated level of risk for what you see as the reward.

These products have become more and more popular among retail investors (in addition to institutional traders). The ProShares UltraShort 20+ Year Treasury Bond ETF (TBT) is the largest leveraged ETF by size with over $3.1 billion in total assets. This fund tracks two times the daily inverse price of a basket of long-term Treasury bonds. In reality, it’s essentially a double short vehicle of the iShares 20+ Year Treasury Bond ETF (TLT).

There are also countless leveraged ETFs that are both long and short domestic and global stocks, commodities, and other fixed-income indices. Before considering one of these tools in your portfolio, I highly recommend that you take a step back and think about the following points:

Don’t Overstay Your Welcome

The most important disclaimer that all leveraged ETFs employ is that the fund is designed to mirror the stated price action of the underlying index for a single day. Each day the leverage is reset and the process starts all over again. This can ultimately lead to issues with the returns of a single beta index not tracking consistently with its leveraged ETF over longer periods of time. In the above example, you can’t expect that a 10 percent loss in TLT over a 6-month period will result in exactly a 20 percent gain in TBT.

The magnification of price action in both directions can also drag on the performance of leveraged ETFs, as it erodes its tracking efficiency over time. These vehicles are designed to capitalize on very short-term moves in the market rather than as long-term holding vehicles. As such, they serve a better purpose for very focused, short-term professional traders.

High Fees

This is another important consideration of leveraged ETFs – they typically carry higher fees. Many of the leveraged funds from ProShares and Direxion Shares carry expense ratios between 0.90% and 1.00% – that is considerably higher than most passive index ETFs (several have expense ratios at or below 0.50 percent).

If you are just looking to trade these vehicles for a week or less, then you likely aren’t concerned about those expenses. That said, they do become an important part of your total investment returns if/when they are used frequently.

High Risk

Most investors are happy with a 10% return on their portfolio in any given year. Yet leveraged ETFs can produce those types of returns in days (if not hours). But it works both ways, as it can turn into a big loss just as quickly. In short, they work well if you have chosen the right side of the market to be on. The consequences of a misstep using a leveraged ETF can quickly erode your capital, hit your overall performance, and make you wish you had never invested to begin with.

Only highly disciplined traders with a stop loss or other risk management tool philosophy should even consider this type of investing vehicle. If you are looking to make a bold directional bet on the market, you may be better served in a single beta ETF with a larger allocation/position size rather than a small slice of a leveraged fund.

The Bottom Line

In simple terms, successful use of leveraged ETFs will require quick entry and exit points. Holding for over a week will likely require a strong understanding of your positioning and an ability to weather speed bumps along the way. Again, careful here.

Much of investing is fighting the psychological pull of 20-20 hindsight. When you get it right, you wish you had taken a larger position or used leverage to magnify your returns. Conversely, when you are wrong, you wish you had seen the potential risks ahead of time and minimized your exposure.

I will admit that I am a conservative investor by nature and would rather take a slow and steady approach to the market rather than heavy amounts of risk. Understanding my investing psychology allows me to select investments that are appropriate for my goals and that align with my risk tolerance.

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No position in any of the securities mentioned at the time of publication.  Any opinions expressed herein are solely those of the author, and do not in any way represent the views or opinions of any other person or entity.