Beware of leveraged ETFs

Exchange-traded funds (ETFs) — which are like mutual funds in many ways, but which trade like stocks — can be great investments for most of us. Many are index funds, often with very low fees. There's a kind of ETF that most investors should avoid, though: leveraged ETFs.

A leveraged ETF often tracks a certain market index or industry, as a traditional index fund might — but with a twist. It employs leverage (a fancy word for debt) in order to amplify gains. It may also use options, futures or other derivatives. A typical leveraged ETF might aim to deliver double or triple the return of an index it tracks — and its name might reflect that via the inclusion of a “2x” or “3x” in its name. (Some just use terms such as “ultra” in their names.) For example, if the Dow Jones Industrial Average rises by 2% one day, the UltraPro Dow30 ETF will appreciate by 6% (less fees).

There are even “inverse” leveraged ETFs: A 2x inverse leveraged S&P 500 ETF, for example, will aim to give investors twice the opposite return of the S&P 500. So if the S&P 500 drops 1% on a certain day, the ETF would go up by 2% (less fees).

This may sound good, but there are several major cautions. Remember that while a leveraged ETF can amplify gains, perhaps doubling or tripling them, it will also amplify losses. So a 3x leveraged ETF can deliver a 10% blow if the index it tracks falls by 3.3%.

Even worse, as these ETFs are focused on daily returns, they're not meant to be long-term investments. Indeed, holding them for days, weeks or months can deliver big losses — and they can even fall in value when expected to rise. This is problematic, as it goes against the rather effective investing strategy of buying shares of terrific businesses (or simply buying into low-fee, broad-market index funds) and hanging on for many years, if not decades.

Unless you have an appetite for risk, steer clear of these ETFs.