The leveraged exchange traded fund (ETF) has gotten a lot of flack over the past few years, but make no mistake: employed wisely, they can be useful.
Bob Seawright for Advisor One reports that these ETFs are designed to provide a multiple of the return of the underlying index.
The twist is that they reset daily. That means that they only reflect the daily moves of the underlying index, which is why you may not always see perfect tracking. A target return for one day is much different than a targeted return over a period of time. Here’s an example:
For example, if the S&P 500 gained 1.2% on a particular day, an inverse leveraged S&P 500 ETF would lose 2.3%. The next day, that inverse leveraged ETF would reset and start over.
In stable markets, this system works well. Over time, however, you will see a leveraged fund drift from its benchmark because of the effects of compounding (holding the ETF for longer than its stated daily objective). The effect is more pronounced in markets where wild swings are occurring, an effect many investors saw at the height of the financial crisis. [Are Specialty ETFs Right for You?]
Because of this effect, inverse and leveraged ETFs that are reset daily typically are unsuitable for retail investors who plan to hold them for long periods of time, particularly in volatile markets. [The Pros and Cons of ETFs.]
Despite the warnings, leveraged and inverse ETFs have some very good uses, including:
- They can be used to play short-term market moves. If you believe that a particular index is going to turn south on a given day, you can purchase an inverse ETF to capitalize.
- They can be used to hedge current positions. If you own gold, for example, but it’s having a bad day, you can purchase an inverse gold ETF to hedge without selling your current position.
- If you have an interest in shorting the markets, leveraged and inverse ETFs allow you to do this without having to open a margin account.
Know the risks, understand the products and proceed wisely and you’ll be in a good position to benefit from these funds. If they aren’t right for you, though – that’s okay, too.
Tisha Guerrero contributed to this article.
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.