Ask a Fool: Are Leveraged ETFs Ever Good Investments?
Q: I've noticed that some ETFs use double or even triple leverage to amplify their returns. Could these work as part of my long-term investment strategy?
Leveraged ETFs are intended to amplify the daily return of their underlying index, not its long-term performance. When the market goes up rapidly, like it has over the past year or so, people who hold leveraged ETFs look like geniuses. However, it's important to realize that leveraged ETFs have a downward bias over long periods of time. Without going too deep into the mathematics of leverage, in a nutshell, bad days (or weeks, months, or years) can eat away at a leveraged ETF's returns.
Consider this simplified example. Let's say that the S&P 500 rises 10%, falls 30%, then rallies 10%. Without using leverage, this would turn a $1,000 investment into $847. Not great performance, but you live to invest another day, and you would need a gain of about 18% to make up for the loss.
On the other hand, a triple-leveraged S&P 500 ETF would turn that into a gain of 30%, drop of 90%, and gain of 30%. Your original $1,000 investment would plunge in value to just $169. Now, you would need a rally of 492% just to get back to even. That's why leveraged ETFs are so dangerous. Of course, this is a simplified example and the market doesn't generally move 10%-30% in a day, but even smaller ups and downs can have a devastating effect over time.
Leveraged ETFs certainly play a valuable role as a hedging vehicle that can be used by professional traders. As a long-term investor, however, you're better off looking elsewhere.
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