With choppy investment markets, you might be tempted to seek higher returns in leveraged ETFs, but they are a loser’s game. Even sophisticated investors get burned by them.
In fact, “very few investment professionals understand the risks over time, let alone retail investors and people in the media,” says Jason R. Escamilla, CEO of ImpactAdvisor. These risky investments don’t work the same way as typical funds and magnify losses exponentially.
[See: 10 of the Worst ETFs of 2017.]
Leveraged ETFs, such as UltraShort S&P500 ETF (ticker: SDS) and Direxion Daily S&P 500 Bull 3X ETF ( SPXL), are short-term trading tools that use financial derivatives to magnify the returns of the underlying index. Derivatives are financial instruments that derive value from another underlying security, such as the Standard & Poor’s 500 index, and are typically used by advanced investors for speculating or hedging. Even derivatives owned through an ETF are not for the typical long-term investor.
Leveraged ETFs are newer investments. In 2006, ProShares launched the first leveraged ETF, and today there are hundreds of similar products. ProShares and Direxion, the biggest providers, offer both bullish and bearish exposure to various sectors, markets, securities and currencies.
Although they promise two or three times the returns of an index, leveraged ETFs do so by betting on the movement of an index using a combination of derivatives such as futures and swaps. Futures are contracts to buy or sell a financial asset, such as a commodity or security, on a future date at a predetermined price. A swap, as its name suggests, is an exchange of one type of asset for another. Since the ETFs’ leverage is reset daily, the compounding effect is drastic.
Leverage sounds great in theory. Using borrowed money on top of your own investment increases the dollar amount that can be invested. If the investment goes well, returns are multiplied — but the reverse is also true. If the market turns against the strategy, then losses are multiplied, says Fred Leamnson, founder and president of Leamnson Capital.
And leveraged ETFs don’t always work the way you might expect. “In certain markets they will dramatically underperform [relative to] the expectations of the everyday investor or finance professional,” says Escamilla.
The daily nature of leveraged ETFs amplifies losses — and gains, if the markets go your way. Consider, for example, the ProShares Ultra S&P500 ( SS0), which promises twice the daily return of the S&P 500. If the S&P 500 drops 5 percent one day, then the ETF should fall 10 percent. If the SSO share price is worth $10, then after one day, it would be worth $9. On day two, if the S&P 500 rebounds and goes up 5 percent, the leveraged ETF will rise 10 percent and be worth $9.90, down 1 percent for the two days.
But the S&P 500 index’s two-day return would be down just 0.25 percent, a decline that is four times smaller than the leveraged fund’s.
[See: 8 Ways to Buffer Your Portfolio From a Market Slide.]
The risks of leveraged ETFs go beyond the one-day time horizon and extreme compounding to include higher fees than typical ETFs. Ian Winer, managing director and co-head of equities at Wedbush Securities, says, “They are very expensive to buy and sell relative to normal ETFs or stock commissions.” Most leveraged ETFs charge approximately 1 percent versus the average ETF management fee of 0.44 percent, and the expense ratio isn’t your only cost. You’ll pay a commission every time you buy and sell an ETF.
If you’re trading leveraged ETFs in a standard brokerage account, you’re also liable for taxes on short-term capital gains. So even if you profit from leveraged ETF trading, your transaction costs will eat into the profits.
There’s no dispute that these investments are best left to day-traders and professionals. “There really isn’t an investment case for leveraged ETFs,” Winer says. “They are a trading vehicle because they are designed to be in and out of the market in a very short period of time [days, if not hours].” Most investors won’t get the returns they’re expecting, adds B Scott Sadler, president and chief investment officer of Boardwalk Capital Management, and Leamnson says, leveraged ETFs are trading vehicles that have no place in a long-term investment strategy. They’ll magnify negative returns and hold down positive returns as well.
Don’t succumb to the allure of hitting it big. These investments exist because in specific circumstances they can benefit investors. If the market goes as anticipated or surprises on the upside, the leverage can amplify returns for a lower price than you’d pay trading derivatives in a margin account, even after paying fund fees, Escamilla says.
With leveraged ETFs, investors can overweight or underweight a particular market segment with a small amount of cash. Inverse exposure might allow investors to benefit from a market decline. If you’re interested in predicting the future direction of specific markets or sectors and potentially benefiting from your ideas, it’s easy to buy a long or short leveraged ETF that reflects your expectations. If your predictions are correct, you can profit handsomely. If they’re not, you’ll pay the price with magnified losses.
For better or worse, risk-seeking investors can buy leveraged ETFs in an individual retirement account, where leverage is normally restricted. Of course, you might not want your retirement dollars subjected to the extreme risk these ETFs pose.
[See: 7 Things That Can Derail Your Retirement Investing.]
With investing, there are no shortcuts or freebies, and if the possibility of hitting it big seems too good to be true, it probably is. “Leveraged ETFs are an attempt to get something for nothing,” says Steven Jon Kaplan, CEO of True Contrarian Investments, who never invests in leveraged ETFs for his clients. “Unfortunately, there is no free lunch.”
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Leveraged ETFs Are a Loser’s Game originally appeared on usnews.com
