This is why only thrill seekers invest in leveraged ETFs

This post was originally published on this site

It is tempting to chase high returns in the market? Maybe. 

Why would you wait a year for 10% return when you could have it all in a day?

Investors chasing high returns will sometimes turn to leveraged in order to double or even triple their returns.  But investing in leveraged ETFs is akin to spinning a roulette wheel.

With high returns comes high risk, and unless you’re an experienced investor you should steer clear of leveraged ETFs.

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These ETFs promise to amplify the returns of an underlying index using debt, equity swaps and financial derivatives to create leverage. Leveraging is an investing strategy that uses borrowed funds to purchase options and futures in order to increase the impact of price movements. It is a very complicated process. And if gains can be amplified — so can losses.

Another problem:  leveraged ETFs only seek results that are leveraged to their benchmark for a single day.  For example, if you buy an ETF that is 2x leveraged to the S&P 500, if the S&P rises 1% that day, you will get a return of 2%, but only for that day.  The ETF resets the next day.  If you are still holding it the following day, your return could be substantially different than 2x.

Not only is there outsized risk but management fees and transaction costs that come with leveraged ETFs can eat away at a fund’s return. Many leveraged ETFs have expense ratios of 1% or more.

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Because of the risks and costs, Leveraged ETFs are typically used by day traders who want to speculate on an index and are rarely used as long term investments.

These same warnings apply to another class of leveraged ETFs — leveraged inverse ETFs, which try to deliver returns that are the opposite of the index’s returns.  So for example, if you had an ETF that was 2x leveraged inversely to the S&P 500, if the S&P went up 1% in a day, your investment would decline 2%. 

The bottom line is unless you intimately understand how these ETFs are designed and can stomach the significant risk associated with them, steer clear of leveraged ETFs.

Disclaimer