Perils Of Leveraged ETFs

April 10, 2014

Figuring returns not the simple multiplication it may seem.

Market Intel - Perils of Leveraged ETFs

Leveraged ETFs are powerful tools for investors, but a full understanding of how they function is crucial to their success. The tricky part is that most leveraged ETFs reset their leverage daily. It's less important to understand the technicalities of how and why this happens and more important to understand the consequences.

The most important consequence is that the vast majority of leveraged ETFs are designed to provide their advertised leverage for one day only. For periods longer than a day, your realized leverage factor is uncertain.

The Direxion Daily Emerging Markets Bull 3x (EDC) provides 3x exposure to the MSCI Emerging Markets Index. In fact, EDC does a great job providing this leveraged exposure. For example, on Feb. 11, the MSCI Emerging Markets Index jumped a little more than 2 percent. Meanwhile, EDC, the 3x leveraged ETF that tracks the index, jumped a little more than 6 percent—as it should.

However, this simple relationship falls apart for holdings periods longer than a day. For example, that same index (MSCI Emerging Markets Index) gained 3.4 percent over the past year. Understandably, a naive investor might expect that a 3x leveraged ETF tracking the index would have returned 10.2 percent over the same period. Far from it: EDC returned -6.4 percent over the past year—a spread of more than 16 percent between what an unwitting investor might assume and what actually happened.

Again, leveraged ETFs truly are powerful and useful tools for investors, but complete understanding of how to use them is key. To learn more about leveraged ETFs, I recommend the following two articles: "Why 2x Is Not the 2x You Think" and "Understanding Monthly Resets."

 

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