Lever­aged ETFs: Dan­ger, Dan­ger!

The Record (Troy, NY) - - BUSINESS -

Most ex­change-traded funds (ETFs) are rea­son­ably sound — or even ex­cel­lent — in­vest­ments. But be­ware of lever­aged ETFs — the ones that tend to have “3x” or “2x” in their names. First, though, un­der­stand what ETFs are. They’re kind of like mu­tual funds (in­dex funds, typ­i­cally) that trade like stocks. You can buy or sell as lit­tle as a sin­gle share, as of­ten as you’d like dur­ing the trad­ing day — but you’re of­ten best served hold­ing on to good ones for years, just as with stocks of great com­pa­nies. Lever­aged ETFs, though, are de­signed to de­liver some mul­ti­ple of the daily per­for­mance of what­ever un­der­ly­ing in­dex the ETF tracks. (A “2x” fund, for ex­am­ple, seeks to dou­ble the in­dex’s re­turn.) But over time, daily move­ments in the un­der­ly­ing in­dex can cre­ate losses for those who hold shares over longer pe­ri­ods of time — even if the in­dex rises over­all.

Here’s a sim­pli­fied ex­am­ple. Imag­ine that the S&P 500 rises 10 per­cent, falls 30 per­cent, then ral­lies 10 per­cent. Without us­ing lever­age, this would turn a $1,000 in­vest­ment into $847. That’s not a great per­for­mance, but you live to in­vest an­other day, and a gain of about 18 per­cent would make up for the loss. On the other hand, a triple-lever­aged (“3x”) S&P 500 ETF would turn that into a gain of 30 per­cent, a drop of 90 per­cent, and a gain of 30 per­cent. Your orig­i­nal $1,000 in­vest­ment would plunge in value to just $169 — and you would need a 492 per­cent re­bound 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 per­cent (or 30 per­cent) in a day, but even smaller ups and downs can have a dev­as­tat­ing ef­fect over time. Both the Se­cu­ri­ties and Ex­change Com­mis­sion (SEC) and the in­de­pen­dent Fi­nan­cial In­dus­try Reg­u­la­tory Au­thor­ity (FINRA) have warned about the risks of lever­aged ETFs. Stick with reg­u­lar, non-lever­aged ETFs, and learn more about them at etfdb.com and fool.com/ in­vest­ing/etf.

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