Leveraged ETFs promise the benefits of fast profits with little concern towards common-sense investing risks. In fact, a good friend and colleague of mine recently wrote an article titled When Do Leveraged ETFs Make Sense? 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.
I will take the other side of that debate and point out that there are a number of important facts you need to know before deciding to invest in these vehicles. Like most things in life – there is no free lunch when it comes to assuming a stated level of risk for a consummate expected reward.
These products have become increasingly 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. It’s essentially double short the iShares 20+ Year Treasury Bond ETF (TLT).
There are also countless leveraged ETFs that are both long and short domestic and international stocks, commodities, and other fixed-income indexes. Before you consider using these tools in your portfolio, take a step back and ponder 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 a leveraged ETF over long periods of time. In the above example, you can’t expect that a 10% loss in TLT over a 6-month period will result in a perfect gain of 20% in TBT.
The magnification of price action in both directions can provide a drag on the performance of a leveraged ETF and erode 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.
