Pitfalls of Leveraged Etfs

The exchange-traded fund or ETF has been around since the early 1990s. The newest version, the leveraged ETF, was offered in mid 2006 after three years of review by the Securities and Exchange Commission. While the original ETFs are built to follow any segment of the market you can imagine, a leveraged ETF mirrors a particular index fund. It promises returns of two or even three times the return of the index fund. It hopes to accomplish these proportionately higher returns by maintaining double (or triple) the exposure to the index by buying and selling derivatives such as futures, options and swaps.

Leveraged ETFs are designed to provide greater returns than holding long or short positions and are the most suitable for short-term (one day) trading. To accomplish these returns, the fund uses both investor funds and leveraged capital. A typical fund could hold a large amount of cash invested in short-term securities. The cash is then available for any obligations that result from losses on the derivatives.

In order to maintain the constant leverage ratio, there must be daily rebalancing to respond to the fluctuating price of the underlying index fund. The more the leverage, the more any gains or losses are magnified. And because of the necessity of daily rebalancing, the actual returns may not correspond to the benchmark returns at the monthly, quarterly or annual periods.

In market downturns, the leveraged ETF requires a slightly larger return than the underlying index fund needs to get back to the original value. This is because of the smaller asset base in the leveraged fund. The longer the market downturn lasts and the greater the percentage of loss, the larger the difference will be.

There are also hidden costs in a leveraged ETF in the form of management fees, interest expense and transaction fees. Management fees that are charged by the fund’s management company are listed in the prospectus. These fees cover administration and marketing costs.

Both interest expenses and transaction fees are not easily seen. The interest expenses are the costs related to holding derivative securities. The built-in rate is called the risk-free rate and is assumed to be approximately the short-term government bond rate. Transaction fees result when the fund needs to be resized and trades have to be made to rebalance to the index fund. One way to calculate them is to follow the ETFs performance over a period of time and compare the result to the underlying index fund.

There can also be tax consequences when you hold a leveraged ETF. Any large capital gains paid will be passed along to each investor.

An inverse-leveraged ETF uses all the same types of derivatives except it sells them short. Therefore, these ETFs profit with the index drops and suffer losses when the index rises. The increased risk here is the same as with any other short investing.

Investors who already use leveraged investing as part of their risk management plan may prefer to control their index exposure and leverage ratio on their own. For these people the leveraged ETF would not be a useful investment vehicle.

There are several companies which currently offer leveraged ETFs such as Direxion, ProShares, MacroMarkets, Market Vectors and Rydex. The offerings include funds tied to market, sector, currency and international index benchmarks. As with all investments careful planning and research is recommended to determine if a leveraged ETF is appropriate for your portfolio.