To date, all ETFs and ETNs seek to provide a multiple of the daily, weekly or monthly return of an underlying index and are unlikely to provide returns that match these multiples beyond each ETF or ETN’s respective time frame. This is because of the effects of compounding.

Misconception: Leveraged ETFs Increase Overall Portfolio Risk

While many investors and advisors view leveraged ETFs as speculative and risky, if used properly they may actually lower a portfolio’s overall risk. Leveraged ETFs and ETNs do not just allow for leveraged exposure, but can also provide an opportunity to access single exposure at half the price. For example, rather than going double-long with the PowerShares DB Commodity Double Long ETN (NYSEArca: DYY), one could invest half of his/her intended investment and gain roughly the same exposure to commodities as the ETN’s non-leveraged counterpart, PowerShares DB Commodity Long ETN (NYSEArca: DPU).

Misconception: Leveraged ETFs Are Too Readily Available and the Average Investor Will Hurt Themselves

Fact: What’s wrong with choices? We’re all adults here. Investors deserve to have options — and the more, the better. Give investors some credit. I know our readers on ETF Trends, and they’re a smart, educated, affluent bunch. It’s up to you and I to get the necessary education so we don’t shoot ourselves in the foot.

Furthermore, the fund companies that issue leveraged ETFs readily admit that their funds aren’t for everyone. They’re very open about the risks. As much as the fund companies want to make money, they also want their investors to be successful . It behooves them to help investors do that. It’s all about understanding risk and knowing what you’re getting into with these funds.

Another point to consider is that it’s hard to know exactly who’s buying these funds, but based on the volume being traded, it would suggest that it’s largely institutional. It’s true that anyone can buy them, but the big players are likely the ones buying them at this point, so their accessibility is probably moot for now.

Misconception: They Exist So Investors Can Sidestep Margins Rules

Fact: It’s really not that sinister. Before leveraged ETFs, investors had to borrow from a broker to short with credit, then have a required amount of reserve capital before doing so. These limitations don’t exist with leveraged ETFs, but I doubt that most investors are arching their eyebrows and laughing wickedly at the thought of sidestepping margins rules.

The less exciting truth is that these funds have simply made it easier for the average investor to employ a strategy he or she might not have had access to before. Additionally, margin rules were set up to protect banks, not investors, so this argument doesn’t hold much water. Investors can only lose what they put into these funds.

Misconception: Leveraged Funds Are Bringing the Market Down

Fact: There are a lot of things making it difficult for the government to save financials, and it isn’t right or fair to put the blame on the shoulders of leveraged ETFs. Trading and interest in them has undoubtedly increased, but billions of shares trade hands each day in funds of all types.

A small fraction of that is leveraged ETFs, and they seem to be getting a far greater percentage of the blame. One industry expert points out that if you look at the net assets in both the long and short funds, the levels are net long in the majority of the fund pairings most of the time. If anything, they’re having a positive effect on the market.

Misconception: They’re Not Buy-and-Hold Investments

Fact: Well, that is true. They’re not. But this isn’t exactly news – many leveraged ETF investors have been able to successfully hedge their portfolios for short-term periods. These ETF providers readily acknowledge that these types of funds are meant to hedge risk, not funds around which one should plan their retirement.

Misconception: Leveraged ETFs Just Don’t Work

Fact: Leveraged ETFs operate exactly as they should— they reset daily (or weekly or monthly). Over a period of time, you’re going to see internal compounding that will affect the returns. This isn’t a flaw in the funds: this is a mathematical fact that is impossible to avoid. If you invested in a leveraged ETF over a period of months and the market went down 20%, a 2x short leveraged ETF wouldn’t go up exactly 40%.

The SEC is ultimately going to find that there’s nothing illegal or underhanded about these products. They’re doing what they’re supposed to do. They’ve proven immensely popular, and the SEC would not impose limits or consider doing away with such innovative products.

Questions to Ask Before You Buy

Since not all leveraged and short ETFs and ETNs are created equal, it is important to understand the structure and risks specific to each fund. A few questions to ask of a leveraged fund are:

  • Does it offer suitable long- or short-term exposure?
  • What are the risks inherent to the fund and the underlying space in which it invests?
  • How are the futures contracts purchased?
  • See “10 Things to Consider When Picking an ETF” for more on picking ETFs.

Watch Tom Lydon discuss leveraged and inverse ETFs on CNBC!

Read the disclaimer; Tom Lydon is a board member of Rydex|SGI.

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