Leveraged ETFs for Beginners

Definition, Introduction, and Dangers of Leveraged ETFs

Leveraged ETF Description
A leveraged ETF can amplify the results of the underlying investments, often by a 2x or 3x. However, the tax inefficiency, fees, and structure make them totally inappropriate for nearly everyone despite Wall Street's delight in sponsoring these financial products. artpartner-images / Getty Images

In all your stock market research and analysis, the odds are high that you have come across something called a leveraged ETF.  (In case you need a refresher, ETF is short for "exchange traded fund", which is a type of mutual fund that is bundled together into shares and traded under a ticker symbol as if it were a stock; bought and sold throughout the day at prices that might be greater or less than the net asset value.)  What is the definition of a leveraged ETF and what makes it so different from its ordinary counterparts?

 Those are fantastic questions.  Let's take a moment to dive in and examine these fairly new securities.

What Is a Leveraged ETF?

For as long as markets have existed, certain people want to speculate; to make a prediction about the direction of a particular asset and win big if their hypothesis turns out to be correct.  In olden, simpler times, this meant buying stock on margin.  Not to be outdone, Wall Street created a super-leveraged security known as the leveraged ETF.  Using borrowed money, futures, and/or swaps, it seeks to amplify the movement of an underlying benchmark, index, or commodity, either positively or negatively (the latter being a so-called "short ETF", alluding to selling stock short).  The first leveraged ETFs were made available to investors in 2006, while their earlier manifestations, leveraged mutual funds, had been in existence since at least the 1990's (prior to that, one would have had to work through a hedge fund, most often setup as a limited partnership, if you wanted to achieve the same thing).

It might help to look at a specific example.  The Direxion Daily S&P 500 Bull 3x leveraged ETF, which trades under ticker symbol SPXL, takes the underlying S&P 500 index and soups it up so that, if all goes according to plan (it doesn't always and there is no guarantee it will), a 1x movement to the upside will produce a 3x movement in the ETF price.

 However, the leveraged ETF resets itself every trading day.  This means if you were to simply buy and hold, under most ordinary volatility conditions, you would have your position reduced to virtually nothing over time as it was taken away by the mechanics of the ETF itself, even if the market did end up going straight to the moon.  This is a nuance lost on some inexperienced investors who buy these instruments meant for short-term (one trading day) speculation.

Leveraged ETFs Have No Place In a Beginner's Investment Portfolio

Though the temptation to speculate with leveraged ETFs may be strong, make no mistake: They have absolutely no place in a diversified, long-term portfolio.  None.  If you have an advisor and he or she has put them into your account, including an individually managed account, or if you have bought them for your own brokerage account, you are behaving with extreme foolishness.  You can, and probably will, lose a substantial amount of money if you keep behaving this way.  This is not investing.  It is raw, unrestrained speculation.  Do not deceive yourself otherwise.

Furthermore, the payoff may not be as rich as you envision.  In addition to these risks, leveraged ETFs typically have investment management fees.

 You will owe brokerage commissions in many cases.  Almost all profits you might enjoy will be short-term in nature, which can be outright confiscatory for investors in the top Federal bracket who also happen to live in a high-tax state such as California or New York, perhaps reaching 40% to 50% of your capital gains.

Why live this way?  Building wealth is simple enough.  You buy high quality, blue chip stocks, take advantage of deferred tax liabilities through low turnover, and let compounding do the rest.