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InvestmentNews Warns Investors to Avoid ETFs

Has your broker or adviser recommended you invest in leveraged exchange-traded funds? If so, you might want to do some extra research to make sure they’re right for you.

A recent piece by Investment News offers stern cautions against leveraged ETFs, warning that the product is often extremely volatile.

A quick refresher: in basic terms, an ETF is a security that tracks assets traded on a stock exchange. An ETF owns the underlying assets – for instance, cattle futures or gold bars – and divides this ownership into shares. Investors who purchase shares in an ETF indirectly own the assets and earn a proportion of the profits on them, perhaps through dividends or earned interest. ETFs tend to bring greater daily liquidity and smaller fees than mutual funds.

Leveraged ETFs are ETFs that trade financial derivatives and debt, rather than stocks, to amplify returns on the underlying index of assets – by as much as 2x or 3x. Leveraged ETFs track daily performance and reset their portfolios at the end of each day. Here’s how Investopedia explains it:

Let’s examine a leveraged fund with a 2:1 ratio. This means that each dollar of investor capital used is matched with an additional dollar of invested debt. If one day the underlying index returns 1%, the fund will theoretically return 2%. The 2% return is theoretical, as management fees and transaction costs diminish the full effects of leverage.

In more concrete terms: let’s say you purchase a stock for $20/share. On the first day it goes up to $25; on the second, it plunges to $15; on the third, it goes back to $20. If you’re a typical buy-and-sell investor, you’ve just broken even. But what if you’re investing in an ETF tracking this stock?

Well, things haven’t worked out quite so well. Suppose your index amplifies daily performance by 2x. The first day sees a 25% gain, which amplifies to 50%. The second day’s loss of 40% amplifies to 80%. The third day’s gain of ~33% amplifies to ~66%. We’ll need to do a little math to see what the overall return is after the ETF resets at the end of three days:stock-exchange-data

(1.00 + .50) on Day 1

(1.00 – .80) on Day 2

(1.00 + .66) on Day 3

At the end of 3 days:

(1.5) x (.2) x (1.66) = .498, which we can round up to .5

In three days, you’ve lost half your investment! Because leveraged ETFs reset at the end of each day, their gains and losses are tracked as a multiple of the previous day’s gain or loss. Because you lost so much money in the second day, it would be virtually impossible for the third day to make a significant difference. This effect is called volatility drag.

Brokerage firms reset leveraged ETFs to prevent them from reaching zero or below – not an unreasonable move, given that leveraged ETFs return a multiple of the change in the index, which could be negative. Volatility drag poses a major and often unforeseen risk, though. Over a long period of time it can significantly diminish your principal investment; a substantial return over a year or two could in fact be a net loss. The downside of leveraged ETFs is basically a side effect of their upside: they magnify gains, but they also magnify losses.

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