Despite the warnings of their inherent risk, leveraged exchange traded funds (ETFs) have become a popular investment tool with financial advisors, hedge funds and intrepid retail investors.

In fact, there are 106 such funds that are holding around $46 billion in assets and trading volumes of these indexes has skyrocketed.  Just take a look at the Direxion Financial Bear 3x fund (FAZ), whose trading volume last week totaled a whopping 23.1 million shares on 2 million outstanding shares, implying that traders are holding the index for an average of 34 minutes, states Jason Zweig of The Wall Street Journal.

Why have these funds become so popular?  Perhaps it could be the way that they are designed, they are meant to amplify the opposite returns of an index.  Some try to double or even triple these opposite returns.  In a time when the markets are going down, which is recently more often than not, these inverse indexes can go up two or three times. Additionally, some believe that these are great tools for a long-term hedge against falling markets.

This sounds like a great way to beat the markets, but these indexes come with risks:

  • First of all, they are extremely volatile.  There returns are predictable relative to the index only if owned for one day or less and over long time periods the funds can wander away from the underlying index like a stray dog. 
  • Secondly, if the market doesn’t follow a straight path, the swings will make it very difficult just to break-even.  Each loss requires a even bigger gain to get back to square one.  In essence, these funds are not a buy and hold vehicle.

For a safer strategy, we recommend that you consider the trend-following strategy.  If you still want to live on the edge and play with these funds, do your homework and really understand how they work.

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.