Leveraged exchange traded funds are finding their way into long-term, strategic investment portfolios. Investors may enjoy augmented returns in the right conditions, but there are risks in holding these products when the stars don’t align.
ETFs with a leveraged component typically try to produce twice or three times the daily performance of their underlying indices.
The strategy has been particularly fruitful in a steady and trending market. For instance, the Direxion Daily S&P 500 Bull 3X Shares (NYSEArca: SPXL), which generates the daily 300% performance of the S&P 500 Index, gained 118.9% in 2013, more than triple the S&P 500 index returns, reports Ashley Lau for Reuters.
“Much more frequently people are calling up and saying, ‘hey, I thought I couldn’t hold these things, but now it’s up 50, 60 percent year-to-date,'” Michael Eschmann, who heads product development at Direxion Shares, said in the article.
More investors are taking the long approach with leveraged funds. According to Eschmann, the number of registered investment advisors utilizing leveraged and inverse ETFs have increased 15% to 20% over the past year. Eschmann said there have been calls “pretty frequently” from investors asking about longer holding periods.
On the other hand, bad bets could get investors in trouble. For example, the Direxion Daily 20-Year Treasury Bear 3X (NYSEArca: TMV), a bet against rising interest rates and falling Treasury bond prices, has declined 14.1% year-to-date. Meanwhile, the iShares 20+ Year Treasury Bond ETF (NYSEArca: TLT) rose 4.8% year-to-date as investors sought out the safety of Treasury bonds in the recent sell-off. [Inverse ETFs to Hedge Against Emerging Market Volatility]
Leveraged products try to magnify the performance of an underlying index over a daily basis. Consequently, due to the compounding effects, investors may enjoy higher gains, but they must also be willing to accept heavier losses, especially in volatile market conditions.
For instance, if a leveraged ETF rises 10% in one day and falls 10% the next, the ETF will end up slightly lower than when it first started. If the starts by falling 10% on the first day, it will require an increase of a little over 11% to get back to its starting price.
However, in steadily increasing markets, such as in stocks last year, the compounding effect has been working for the leveraged ETFs.
For more information on geared products, visit our leveraged ETFs category.
Max Chen contributed to this article.