The Stock Market's Riskiest ETFs

At a time when too much debt on the part of everyone from homeowners to hedge funds brought the world financial system to the brink, you'd think "leverage" would be a four-letter word. But if the explosive growth of leveraged exchange-traded funds is any indication, it seems like investors just can't get their hands on enough money in order to boost returns.

True, leveraged ETFs offer a cheap, liquid and transparent way to double- or even triple-down on the movements of their underlying indexes — both long and short — but they are unsuitable or even dangerous if you don't understand the product.

Unfortunately, most regular folks just don't.

"For the most part leveraged ETFs are completely inappropriate vehicles for individuals," says Maury Fertig, partner at Relative Value Partners, an independent investment advisor in Northbrook, Ill. "They have to be constantly evaluated. It's a lot more work and risk. And just knowing how most individuals manage their money, why do it? You have to babysit the thing."

True, for professionals and sophisticated day traders, leveraged ETFs can make a lot of sense. They offer cheap leverage at a time when credit is hard to come by and can provide a chance to recoup losses more quickly when bet right. "The bear market has contributed to their explosive growth," says Tom Lydon, president of Global Trends Investments and ETF Trends. Investors looking to maximize any uptrends and hedge any potential losses turned to leveraged ETFs to make a little extra cash, he says.

Indeed, about three years ago there were no leveraged ETFs. Today there's more than 120, holding $30 billion in assets, according to Index Universe. In just one example, Direxion Daily Financial Bull 3X Shares ETF [FAS] (FAS) started the year with $175 million is assets. Today that figure stands well north of a billion.

But that explosive popularity doesn’t mean retail investors should join the fray. Leveraged ETFs require great vigilance because they rebalance daily. When the market is volatile, with sustained swings in either direction, the leverage (and the effect of compounding) can make them diverge wildly from what the unwitting investor expects them to do.

Leveraged ETF providers make this clear in their advertising and prospectuses. And spokespeople from leveraged ETF managers firms like Direxion and Rydex have told us that financial professionals, not retail investors, are their focus, a point backed up by Lydon. "The ETF providers have been very open and clear about the risks," Lydon says. "These funds do what they are supposed to do. But if you're not going to watch them every day, don't bother buying them."

Alas, too many folks just don't seem to get that when an ETF rebalances daily, they need to rebalance almost daily, too. For a stark example of what can happen over time if you don't keep attentive tabs on your leveraged ETF bet, have a look at the chart below:

This chart compares the year-to-date performance of the SPDR Financial Select Sector ETF [XLF] (XLF) with the Direxion Daily Financial Bull 3X Shares ETF [FAS] mentioned above. The latter is essentially supposed to provide three times the daily return of the former. Note that although XLF is off about 2% in this chart, the tripled-leveraged fund is hardly down 6%. Rather, it's off nearly 60%.

Talk about needing a babysitter.

"The average investor doesn't understand the math involved well enough to see what the leverage and daily rebalancing does," says Tim Bearden, managing partner at Stonebridge Financial Partners, a Bingham Farms, Mich., financial services firm. "It's kind of the old, 'Well I'm down 50% so I have to earn 50% to get even.' Well, no. You have to earn 100% to get back where you were."

In another caveat, one of the great selling points of ETFs is that they tend to be more tax-advantaged than mutual funds. But that's not necessarily the case with leveraged ETFs.

Consider that for 2008, Vanguard, which offers no leveraged ETFs, reported no capital gains distributions. But ProShares, which specializes in leveraged ETFs, expected 35 of its 76 funds to kick off capital gains distributions.

Finally, let's also not forget that the need to constantly rebalance your leveraged ETF positions also means that you'll be churning your portfolio — and racking up commissions and fees in the process. That's just another reason why leveraged ETFs don't make sense for long-term investors.

"If you are really hell-bent on leveraging and you are a buy-and-hold investor, you're better off going with a margin account," Bearden says.