Leveraged ETFs: Danger, Danger!
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.