Over time, it has been proven that levered exchange traded funds (ETFs) show greatly magnified disparity and erosion. But do most investors understand how or why?
Know the Risks. These funds are quite different than your average run-of-the-mill fund. They are great tools to hedge, are extremely volatile, and give double or triple the exposure to a specific sector or market. In a nutshell, they do what they are designed to do, but their mathematical makeup results in internal compounding, which can have a dramatic effect on values.

Elaine Southard of Seeking Alpha gives us an example of how this phenomenon works:

• On a double levered ETF, a 20% loss on $1,000 results in a drop of $400. Compare this to a triple levered ETF, which generates a loss of $160 on the same 20% loss, or a hit of 4 times the initial loss.
• Now repeat this over 14 cycles of both ups and downs, and the end result is a loss of 43.5% – it is almost impossible to have gains and losses of exactly 20% every trading session, this is just to emphasis the mathematics behind these funds.

Know What You Own. This is just the way that these funds have been constructed and doesn’t necessarily make them good or bad. Consider this just part of knowing the risks of such funds and being aware of how they work.

If you do want exposure to these ETFs, really do your homework, understand the ins and outs of these tools and keep in mind that these funds aren’t meant for a buy and hold strategy.

Tags: ETF 101, Financial, Long-Short ETFs