Buyer Beware: Leveraged ETFs Amplify Investor Returns for Better or Worse

Henry Truc |

Leveraged ETFsStock traders and investors may have noticed that the swings in the U.S. financial markets aren't as volatile as they were a few years ago. While this is most definitely easier to stomach for long-term self-directed investors, more avid traders and institutional buyers may feel the yearning for vehicles that provide a little more movement, and thus creating more opportunities to make a profit. This is most likely why leveraged ETFs are still a favorite for stock traders.

At the height of the financial crisis, market volatility was at unprecedented highs. Investors would see major indices like the Dow Jones Industrial Average, the S&P 500, and Nasdaq Composite swing anywhere in the 5 percent range in a single day. This was essentially a year's worth of market performance captured in one trading session. Eventually, you could even argue that traders became a bit desensitized to the bipolar market and need more volatility. Braver souls ventured into the arena of leveraged ETFs, which is still not completely understood by most investors.

What Are Leveraged ETFs

A traditional exchange-traded fund typically tracks an index of stocks or specific market in hopes to capture its performance for investors. Popular ETFs by volume include the SPDR S&P 500 (NYSE: SPY), which tracks the S&P 500; iShares MSCI Emerging Markets Index (NYSE: EEM), which owns a diversified basket of emerging market holdings; and PowerShares QQQ Trust, Series 1 (NYSE: QQQ), which follows the Nasdaq 100.

The job of a leveraged ETF is to track its corresponding target of stocks and investments, but amplify its returns by the designated multiple. For example, look at ProShares Ultra S&P 500 (NYSE: SSO), which "invests in equity securities and derivatives that Proshare Advisors believes, in combination, should have similar daily performance characteristics as twice (200 percent) the daily return of the index." In essence, it's supposed to do twice what the SPY is designed to do.

Most Popular Leveraged ETFs

The two companies that dominate the leveraged ETF space are Proshares ETFs and Direxion Funds. Proshares provides many of the 2x and inverse performing ETFs, while Direxion seems to have the 3x products pretty well covered. But leveraged ETFs aren't just focused on the broader market. Like traditional ETFs, they also capture sub-sectors and industries that allow niche investors to more accurately manage their portfolio.

The most popular leveraged ETF by volume is the Direxion Daily Financial Bull 3X Shares (NYSE: FAS), which owns a basket of major financial stocks to create 300 percent of the price performance of the Russell 1000 Financial Services index. Proshares Oil & Gas (NYSE: DIG) and Direxion Daily Energy Bull 3X Shares (NYSE: ERX) are a few examples of leveraged ETFs that allow traders to play the energy trends as well.

ETF Trading Not Investing

It is imperative that investors looking to add leveraged ETFs into their portfolios understand how these financial instruments actually work. Due to the way they are constructed, a leveraged fund isn't supposed to mimic its target index for too long, and after a certain period or time, the price performance doesn't really reflect the actual performance any longer. Most leveraged ETFs are designed to correspond to a multiple of the daily return. Anything beyond that is subject to the adjustments of the fund rebalancing, and will skew the long-term returns.

While adding a few leveraged ETFs into your portfolio may be a good idea, it is important that you understand what exactly to expect in terms of performance and how it weighs against your other holdings. But then again, that should apply to any investment.

DISCLOSURE: The views and opinions expressed in this article are those of the authors, and do not represent the views of equities.com. Readers should not consider statements made by the author as formal recommendations and should consult their financial advisor before making any investment decisions. To read our full disclosure, please go to: http://www.equities.com/disclaimer

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