Best of the Week
Most Popular
1. Investing in a Bubble Mania Stock Market Trending Towards Financial Crisis 2.0 CRASH! - 9th Sep 21
2.Tech Stocks Bubble Valuations 2000 vs 2021 - 25th Sep 21
3.Stock Market FOMO Going into Crash Season - 8th Oct 21
4.Stock Market FOMO Hits September Brick Wall - Evergrande China's Lehman's Moment - 22nd Sep 21
5.Crypto Bubble BURSTS! BTC, ETH, XRP CRASH! NiceHash Seizes Funds on Account Halting ALL Withdrawals! - 19th May 21
6.How to Protect Your Self From a Stock Market CRASH / Bear Market? - 14th Oct 21
7.AI Stocks Portfolio Buying and Selling Levels Going Into Market Correction - 11th Oct 21
8.Why Silver Price Could Crash by 20%! - 5th Oct 21
9.Powell: Inflation Might Not Be Transitory, After All - 3rd Oct 21
10.Global Stock Markets Topped 60 Days Before the US Stocks Peaked - 23rd Sep 21
Last 7 days
BREWING FINANCIAL CRISIS 2.0 Suggests RECESSION 2022 - 28th Jan 22
Financial Stocks Sector ETF XLF $37.50 Continues To Present Opportunities - 28th Jan 22
Stock Market Rushing Headlong - 28th Jan 22
The right way to play Climate Change Investing (not green energy stocks) - 28th Jan 22
Why Most Investors LOST Money by Investing in ARK FUNDS - 27th Jan 22
The “play-to-earn” trend taking the crypto world by storm - 27th Jan 22
Quantum AI Stocks Investing Priority - 26th Jan 22
Is Everyone Going To Be Right About This Stocks Bear Market?- 26th Jan 22
Stock Market Glass Half Empty or Half Full? - 26th Jan 22
Stock Market Quoted As Saying 'The Reports Of My Demise Are Greatly Exaggerated' - 26th Jan 22
The Synthetic Dividend Option To Generate Profits - 26th Jan 22
The Beginner's Guide to Credit Repair - 26th Jan 22
AI Tech Stocks State Going into the CRASH and Capitalising on the Metaverse - 25th Jan 22
Stock Market Relief Rally, Maybe? - 25th Jan 22
Why Gold’s Latest Rally Is Nothing to Get Excited About - 25th Jan 22
Gold Slides and Rebounds in 2022 - 25th Jan 22
Gold; a stellar picture - 25th Jan 22
CATHY WOOD ARK GARBAGE ARK Funds Heading for 90% STOCK CRASH! - 22nd Jan 22
Gold Is the Belle of the Ball. Will Its Dance Turn Bearish? - 22nd Jan 22
Best Neighborhoods to Buy Real Estate in San Diego - 22nd Jan 22
Stock Market January PANIC AI Tech Stocks Buying Opp - Trend Forecast 2022 - 21st Jan 21
How to Get Rich in the MetaVerse - 20th Jan 21
Should you Buy Payment Disruptor Stocks in 2022? - 20th Jan 21
2022 the Year of Smart devices, Electric Vehicles, and AI Startups - 20th Jan 21
Oil Markets More Animated by Geopolitics, Supply, and Demand - 20th Jan 21
WARNING - AI STOCK MARKET CRASH / BEAR SWITCH TRIGGERED! - 19th Jan 22
Fake It Till You Make It: Will Silver’s Motto Work on Gold? - 19th Jan 22
Crude Oil Smashing Stocks - 19th Jan 22
US Stagflation: The Global Risk of 2022 - 19th Jan 22
Stock Market Trend Forecast Early 2022 - Tech Growth Value Stocks Rotation - 18th Jan 22
Stock Market Sentiment Speaks: Are We Setting Up For A 'Mini-Crash'? - 18th Jan 22
Mobile Sports Betting is on a rise: Here’s why - 18th Jan 22
Exponential AI Stocks Mega-trend - 17th Jan 22
THE NEXT BITCOIN - 17th Jan 22
Gold Price Predictions for 2022 - 17th Jan 22
How Do Debt Relief Services Work To Reduce The Amount You Owe? - 17th Jan 22
RIVIAN IPO Illustrates We are in the Mother of all Stock Market Bubbles - 16th Jan 22
All Market Eyes on Copper - 16th Jan 22
The US Dollar Had a Slip-Up, but Gold Turned a Blind Eye to It - 16th Jan 22
A Stock Market Top for the Ages - 16th Jan 22
FREETRADE - Stock Investing Platform, the Good, Bad and Ugly Review, Free Shares, Cancelled Orders - 15th Jan 22
WD 14tb My Book External Drive Unboxing, Testing and Benchmark Performance Amazon Buy Review - 15th Jan 22
Toyland Ferris Wheel Birthday Fun at Gulliver's Rother Valley UK Theme Park 2022 - 15th Jan 22
What You Should Know About a TailoredPay High Risk Merchant Account - 15th Jan 22

Market Oracle FREE Newsletter

How to Protect your Wealth by Investing in AI Tech Stocks

Understanding The Dangers of Leveraged ETFs

InvestorEducation / Learning to Invest Jul 02, 2009 - 09:19 AM GMT

By: Money_and_Markets

InvestorEducation

Diamond Rated - Best Financial Markets Analysis ArticleRon Rowland writes: You’ve probably heard about leveraged ETFs: Funds designed to deliver twice or even three times the return of their benchmarks.

Just last week, ProShares launched the first triple-leveraged ETFs tied to the S&P 500 index. ProShares UltraPro S&P 500 (UPRO) is a 3x ETF for bulls, while ProShares UltraPro Bear S&P 500 (SPXU) is a 3x leveraged inverse ETF.


What a deal! Wouldn’t it be great to double or triple your gains? Far be it from me to throw water on the party, but I have to tell you it’s not quite so simple.

Yes, leveraged ETFs can be very useful in some circumstances. But before you put a penny into any leveraged ETF, you need to know exactly what you’re getting into.

How They Work …

The good news is that leveraged ETFs almost always do what they’re designed to do. The bad news is that way too many investors don’t understand what these ETFs are designed to do — and expect more than the fund sponsors ever promised to deliver.

Don't take this car off road!
Don’t take this car off road!

Think about it this way: If you want to crash your way through the forest, you buy a Hummer. If your goal is to win a drag race, you get a souped-up Chevy.

But if you try to drive the Chevy across a river, you probably won’t make it, any more than you can hit 150 mph in the Hummer. In either case, you’ve chosen a vehicle that is unsuitable for your purpose. Blaming the manufacturer is pointless; they never told you to use their products as you did.

What people don’t understand about leveraged ETFs: The 2x or 3x leverage factor can change dramatically, depending how long you own the fund. That’s because the leverage is reset every day.

This means that even if a leveraged ETF’s benchmark moves sideways, its value could still melt away like butter in a microwave oven.

Over time, the result can be a huge mismatch between what you think you should get and what you actually do get. In nearly every case, the long-term performance of both the long and inverse versions of leveraged ETFs will underperform their benchmark indexes.

Effects of Daily Leverage

The graph to the left gives a quick illustration: Suppose your benchmark index goes up from 100 to 105 in one day. That’s a 5 percent gain. Then the next day it drops back to where it started at 100. Then the next day back to 105, then back to 100, and so on.

By the time 10 days have passed, the index is back at 100, and an unleveraged investor is at break-even. But a 3x long ETF (green line) based on this index will actually have dropped about 7 percent under the same conditions. A 3x inverse ETF (red line) will be down almost 14 percent!

Why is this?

It’s the magic of compounding at work, only this time it’s working against you. Every day you hold one of these ETFs, your leverage factor drifts a little bit away from where you started at 3x. And if it moves the wrong direction, suddenly you have to dig yourself out of a hole.

Typically the difference isn’t much on any one day. But if you stay in the position for long, the difference will be dramatic — especially if the market you’re trading makes a big swing.

Let’s look at a real-world example …

Suppose last November, when everyone thought the banking system was about to collapse like a house of cards, you decided to buy Direxion Financial Bear 3x Shares (FAZ). This is an inverse leveraged ETF that is based on the Russell 1000 Financial Services Index.

On November 6, 2008, the index value closed at 720.446. Five months later, on April 6, 2009, the index ended the day at 520.629, for a drop of 27.7 percent.

So how do you think FAZ performed during this time? As an inverse fund, it should go up as the index goes down — and because FAZ is leveraged by a factor of three, your gain should be amplified three times over, right?

You might calculate that FAZ would have gone up 83.1 percent for this period (27.7 x 3 = 83.1).

Wrong …

In fact, FAZ actually fell 76.9 percent! Even if you correctly guessed that the financial sector would fall in this period, FAZ didn’t help you profit from your forecast if you held it the entire time. Quite the opposite — you lost money despite being right about the market’s direction.

This ETF dropped right along with the market!

Source: Bloomberg

How can this be? Is Direxion at fault? No, not at all. Their fund does exactly what the prospectus said it will do: Deliver a 3x inverse daily return on the index. Compounding — and your own decision to buy and sell FAZ when you did — are responsible for the rest.

Of course, if you get the timing right, the results can be spectacular!

For example, if you were lucky enough to buy FAZ on January 6 of this year and sell on January 20, you racked up a sweet gain of more than 160 percent. The index only fell by about 32 percent during that time, so your leverage wasn’t 3x — it was more like 5x!

This would have been a nice gain. But still, if you knew ahead of time you would be investing with such high leverage, would you have done it? The answer will depend on how aggressive of an investor you are, and how much confidence you have in your ability to time the markets.

Bottom Line: Leveraged ETFs Can Be Great, But You Must Use Them Correctly!

Leveraged ETFs are mainly intended for short-term trading. And by short-term, I mean a few days at most. Stick around any longer and the results will start to vary wildly.

Market regulators are starting to realize this. Just last month, the Financial Industry Regulatory Authority, or FINRA, warned brokers that leveraged ETFs are too risky for investors who intend to hold for more than one day. Unfortunately, most stock brokers don’t understand how leverage works, either.

If you're a day trader or have an expert guiding you, leveraged ETFs can make you a heap of money.
If you’re a day trader or have an expert guiding you, leveraged ETFs can make you a heap of money.

On the other hand, if you’re a day trader — someone who watches the market minute-by-minute and closes out your positions every evening — then leveraged ETFs can be a great tool.

They can also be useful over longer periods if you know what to expect and watch your ETFs like a hawk, or if you have someone trustworthy watching them for you.

The sponsors of these ETFs are doing their best to educate investors, but it’s hard to get the message out. Here are links where you can get information: DirexionShares, ProShares, and RydexShares. I highly recommend you take some time to educate yourself on these ETFs before you use them on your own.

Best wishes,

Ron

This investment news is brought to you by Money and Markets . Money and Markets is a free daily investment newsletter from Martin D. Weiss and Weiss Research analysts offering the latest investing news and financial insights for the stock market, including tips and advice on investing in gold, energy and oil. Dr. Weiss is a leader in the fields of investing, interest rates, financial safety and economic forecasting. To view archives or subscribe, visit http://www.moneyandmarkets.com .

Money and Markets Archive

© 2005-2019 http://www.MarketOracle.co.uk - The Market Oracle is a FREE Daily Financial Markets Analysis & Forecasting online publication.


Comments

wes rude
12 Jul 09, 14:14
FAZ returns clarified

Here is better explanation why FAZ can be a very wrong investment even in a falling market.


Post Comment

Only logged in users are allowed to post comments. Register/ Log in