Leveraged and inverse exchange traded funds (ETFs) can give investors the opportunity to capture two or three times the movement in a particular index, but they can also come with some other things about which investors should be mindful.

If played right, these tools enable traders and speculators to get more bang for their buck, exploit quick market swings, bet against the markets, have an additional hedging tool in their arsenal and the ability to gain leveraged access to the markets in a liquid vehicle without trading on margin.

In the short-term, these ETFs can be utilized by seasoned and knowledgeable investors, however, they’re not meant to be used as a buy-and-hold tool.  John Spence for MarketWatch outlines the following reasons why:

  • Losses are magnified when moving against the trade
  • Market volatility plays havoc with performance over longer periods and daily compounding of the leveraged ETFs takes its toll
  • Traditional tax-efficiency of ETFs is lost because these levered and inverse ETFs keep assets in a pool of cash and use swaps and derivatives to deliver performance- these contracts are almost always settled in the short-term and tend to accumulate large capital gains

Just like every other ETF, these funds offer the same trading advantages of liquidity, timeliness, low commissions and the opportunity to hedge.  Before playing this market, one must really do his or her homework and understand how these funds work, assess his appetite for risk and consult with both his tax accountant and financial advisor. Not all products work for all investors, so understanding what works for you is important.

The opinions and forecasts expressed herein are solely those of Tom Lydon, and may not actually come to pass. Information on this site should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product.