Author: Joanna LiCalsi (Law Student, Investor Justice Clinic, University of San Francisco School of Law)
To begin with, a very basic understanding of what leveraged mutual funds and exchange traded funds (ETFs) are and how they work is crucial to understanding their extreme risk. First, an issuer decides which index to track - this could be broad like the S&P 500 or more specific, like commodities or currencies. The goal is to outperform the indexes by doubling, and even tripling returns (depending on the fund - some names include "2x" and "3x" to denote the specific goal). Marketed as complex and sophisticated instruments for the common investor, leveraged ETFs are attempting to magnify daily market moves through the use of a massive amount of leverage (aka debt) and a strategy, which includes short sales, swaps, derivatives, options, and futures (many compare the strategy to trading on margin). Inverse ETFs work the same way, but in reverse, by betting on down-markets in an attempt to get multiplied inverse returns. Using leverage magnifies gains, but don't forget - losses are magnified too!
In order to achieve the phenomenal, promised returns for leveraged ETFs, managers must vigilantly watch over the funds, maintaining equal proportions of debt and equity at all times. For example, if the market drops, a manager will need to sell many shares in order to reduce the debt level and hold the necessary ratio. This applies to a bull market in reverse (ie. if the market goes up, shares must be bought to get back to the correct amount of leverage). This incredible amount of turnover through constant buying and selling increases exposure to the market, and therefore, volatility.
Let's take a step back - remember, the goal here is doubling the daily return, not annual, quarterly, or even weekly. This means that daily returns are compounded (or reset) at the close of each trading day. The ultimate effect of this strategy is that in the midst of daily debt/equity rebalancing within the fund, any losses are locked in and total asset levels decline. This game of musical chairs with portfolio holdings makes it harder to recover when the market rises again; these effects are amplified in times of market volatility. Financial experts have called this the "Constant Leverage Trap," and it can be responsible for negative returns over the long-term even if the market has been on an overall upswing due to the creation of multiple negative returns. So, buy-and-hold investors, beware: the longer they're held, the less correlation there is between the projected fund returns and the actual index performance.
Because leveraged ETFs may be bought and sold like stock, some sell themselves by claiming to offer greater market exposure with less capital requirements. But you'll find yourself paying in other ways. The incessant juggling of holdings (to maintain proper leverage ratios) results in higher management and commission fees, transaction costs, and short-term capital gains (a red flag for tax inefficiency).
There is no way to overemphasize this point: Leveraged ETFs are absolutely inappropriate for intermediate and long-term investors. Some financial experts say they're best suited for market-savvy day-traders, others say only financial professionals should dabble in these highly risky securities, and yet others contend that this breed of investment is best avoided by everyone. In fact, many professional brokers won't go near them anymore, with several major brokerage firms ending their sales.
See related blog postings:
If It Looks Too Good to Be True, It's Probably a Leveraged (or Inverse) ETF
Securities Regulators Step Up Oversight of Leveraged and Inverse ETFs
Are Leveraged and Inverse ETFs Suitable for You?