Exchange Traded Funds (ETFs) are very popular among all investors because of their low management fees, simplicity, and ability to mimic popular market indices, sectors, etc. They simplify the game of investing by allowing investors to invest in one ETF versus the fifty+ companies that make up that ETF.
With this though comes unseen risks that over time have become more noticeable. ETFs offering double and triple leverage have emerged in the last few years that are great for active day traders but not so good for long term investors. The volatility and complexity of these leveraged instruments have made them much more risky because they do not do fulfill their intended purpose.
To explain why ETF Guide today offers some professional insight:
There is the misconception, however, that the magnified DAILY performance multiplied by a longer period of time, will also result in accurate long term performance mirroring. This is not so.
Due to the compounding effect of leveraged performance, the long-term performance of leveraged ETFs can deviate substantially from the underlying index. According to an in-depth study by ETFguide.com, the performance tracking error becomes particularly pronounced during periods of volatility (available in the April issue of the ETF Profit Strategy Newsletter).
The fourth quarter of 2008 marked such a period of volatility. Even though the Dow Jones (DJI: ^DJI) was essentially range bound, some leveraged short ETFs deviated from their perceived long-term objective by 20% and more.
As much as volatility hurts the performance of leveraged ETFs, especially in combination with a non-directional market, a directional market actually helps the performance of leveraged ETFs. This, once again, is due to the effect leverage has on compounding interest. Once more, timing is key.
Because of this it is highly recommended that traditional, longer term buy and hold investors stay away from leveraged (2x, 3x) ETFs whether they be short or long altogether. After all is said and done even the low management fees cannot save investors from ETFs deviating far from their long term objectives.
Further reading, ETFs:
- 40 Inverse ETFs For Bearish Investors
- 24 Ultra Long ETFs For Bullish Investors
- Triple Leveraged ETFs
- ETFs vs ETNs, the Difference
- US Treasury ETFs
Short and Leveraged ETFs – 3 Pitfalls You Shouldn’t Ignore
ETFGuide.com, Aug 19, 2009