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With markets so volatile, are leveraged ETFs a smart play?

I'm 32 and have recently moved away from mutual funds and have been using more ETFs in my portfolio. The additional yield from derivatives is enticing, but I keep reading to stay in traditional index funds.

Feb 17, 2012 by Tyler from Roanoke, VA in  |  Flag
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Don Level 19

Hi Tyler,

My first question back to you would be for what objective are you investing. Typically someone who is 32 is interested in yield only secondarily, since you are probably working for a living and earning income that way. Most people your age invest for long-term growth. Now yield and growth are not mutually exclusive, but they are different points of emphasis for a portfolio. The other important consideration is your time horizon. Long-term investing utilizes very different strategies than short-term trading.

Now with respect to leveraged ETFs, they are typically used by short-term traders to play hunches about market movements. I personally have used only one, to play a client's hunch on the price of oil. It worked out well, but the fact is that these things can be pretty unpredictable. Increased volatility makes them even more unpredictable. The larger the price swings that are multiplied, the less likely the leveraged ETF is to track the underlying index.

Take an example where you buy an ETF and the index quickly loses 10%. That loss is then followed by a 10% increase. In a 1X fund you will be down 1% (0.9 x 1.1 = 0.99). In a 2X leveraged ETF you'd be down 4% (0.8 x 1.2 = 0.96). That's twice the loss you would expect. This tracking error can add up over time.

These funds also have higher fees than straight index funds, so over the course of many years that can take a significant bite out of your returns.

If at 32 you really want yield for some reason and have an appetite for risk but want an investment that will perform more predictably than a leveraged ETF, consider a closed-end mutual fund. Many of these funds employ leverage in the more traditional sense, which is to say they actually invest with borrowed money to juice returns.

But always remember why you are investing and make sure you are employing a strategy consistent with that objective.

Comment   |  Flag   |  Feb 17, 2012 from Middlebury, VT

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Unless you are a full time investor, the best thing you can do for yourself is to keep your investments simple. Aside from the numerous structural deficiencies inherent to leveraged ETFs, they introduce unnecessary risk to an individual's portfolio. The vast majority of the average American's wealth will be built by saving and investing on a very long term basis. If you're only 32 that goes double for you.

Comment   |  Flag   |  May 08, 2013 from Santa Monica, CA

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I would like to add to other responses. In my opinion, leveraged and inverse ETFs should only be used by Traders and not Investors. These are great investment vehicles for expressing a short term trade vs. a longer term investment. Be extremely careful and diligent when using these as it is easy to get burned, as sometimes What You See is NOT What You Get!

Comment   |  Flag   |  May 01, 2013 from Appleton, WI

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Leveraged ETF are only truly leveraged for a short term trade. If held for a longer term and you were shorting an index, such as Real Estate, and it went down you are not guaranteed to make money. In fact leveraged REITS actually lost money in 2008 because of how it went down. All this being said when you are making a short term trade it is purely a directional trade. There is always someone that is betting the opposite of your bet. Often that someone is a something; a large institution, Yale Endowment fund, Goldman Sachs etc. Who has more resources of power? Think of it as you playing tennis against an unknown hobbled opponent in Las Vegas and he turns out to be Andre Agassi. He wins you lose! Even if it’s a Joe regular guy trader you are both gambling on a direction. You are not investing or even speculating you are gambling.

If you can't control this urge to "beat the market" do so with a small amount of money and the rest in a globally diversified portfolio of indexed stocks and bonds. If you want excess return tilt toward value and small value funds ala French and Fama's three factor model. Small value has had the best return of any broad based asset class but since there is no free lunch in the investment world it has the most risk.

Since you are young saving an adequate amount of money is much more important then any investment you will ever choose!

Comment   |  Flag   |  Feb 17, 2012 from Cleveland, OH

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David Fabian Level 19

In my experience, the worst mistakes in investors portfolios generally come from using leveraged ETFs. The losses quickly compound and the gains are often eroded by the effects of tracking error and compounding over time. A leveraged ETF is only designed to track the DAILY price movement of its underlying index. Therefore, if an index returns 10% over a six month time frame you generally won't be able to correlate that to a 20% return in a 2x leveraged ETF. This can be frustrating to investors that don't understand how this effects their returns.

If you do decide to use these funds I would highly recommend that you employ tight stop losses and adhere to a strict trading discipline to ensure that you define you risk. You don't want to buy and hold a leveraged position and let it get away from you.

Comment   |  Flag   |  May 01, 2013 from Irvine, CA

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Lee Munson Level 16

Stop! Leverage? Really? Then you mention dividend yield. Start over - you made a good move by not engaging in most active funds and using ETFs. It's a great start of someone who has no professional help. Don't waste your time reading how leveraged ETFs are a bad investment. You already know that. They are designed for degenerate gamblers that the financial media refers to as day traders. You don't need dividend yield - you need total return. Liquid ETFs are one of the better way to get the returns of markets including their dividend yield. Keep working on your career, family, and overall life. Don't let Wall Street get you off your dime.

Comment   |  Flag   |  May 08, 2013 from Albuquerque, NM

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