Leveraged ETFs

ETFs are a decent alternative to index funds. They are low cost, allow investors to trade intraday and can offer exposure to subsectors and geographies not served by traditional index funds.

Leveraged ETFs are as their name implies doing the same gig but with 2x or 3x leverage. ETFs have been a hot product over the last couple of years. What follows from that is that the companies issuing them do a lot of advertising and financial media folk are loathe to say anything negative.

The WSJ took a shot this weekend, pointing out that in periods of extreme volatility, it is almost impossible for a leveraged ETF to produce exactly a multiple of the underlying security's performance. Therefore they should be used by short term traders, not long term investors looking for a hedge.

"Let's say you were bearish on China and invested $10,000 in ProShares UltraShort FTSE/Xinhua China 25 on Oct. 9, 2008. Each day the Chinese market went down, this double-reverse fund went up twice as much. It also fell twice as much on any day when China rose.

These swings make it hard for a leveraged fund to match its targeted return in the long run; each loss requires a bigger gain just to get back to break-even. As the Chinese market heaved up and down over the next nine tumultuous trading days, $10,000 invested in Chinese stocks would have dropped to less than $9,200, a cumulative loss of 8%. Did the ultra-short fund deliver twice the opposite, or a 16% gain? No: According to data from Morningstar, it shriveled to $7,838, a 21.6% loss. So much for longer-term hedging."

Be careful out there.