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May 15, 2009

If you're not using a leveraged or inverse fund these days, your chances of owning a top-performing ETF is greatly reduced.

On the other hand, if you do own a leveraged or inverse ETF, thatdoesn't guarantee a winning hand. In fact, it might ensure just theopposite.

 

If you're not using a leveraged or inverse fund these days, your chances of owning a top-performing ETF is greatly reduced.

On the other hand, if you do own a leveraged or inverse ETF, that doesn't guarantee a winning hand. In fact, it might ensure just the opposite.

With leverage, if your ETFs haven't made any of the "best" lists lately, chances are you're going to wind up a big-time loser.

In the world of highly charged ETFs that provide 200% or even 300% leverage of their underlying indexes, few performance numbers fall in between the cracks. It's an all-or-nothing game.

For example, if you'd bought the Rydex Inverse 2x S&P 500 ETF (NYSE: RSW) one year ago today, you would've gained more than 40% by now. If you'd bought the ProShares Ultra S&P 500 ETF (NYSE: SSO) in that same period, you would've lost 60%-plus.

The only real pattern showing up since the onslaught of leveraged and inverse ETFs on the market is that leaders will more likely than not come from one of those two categories. Whether it's one or the other is dependent, of course, on the particular cycle at the time.

So how can you hope to own a real ETF winner without juicing up your portfolio these days?

It's easier than you think. And best of all, you really don't need 2x or 3x ability to be a top performer. In fact, it's probably counterproductive for most long-term investors to own a leveraged ETF.

A Historical Perspective

A few years ago, when international equities were outperforming and the U.S. dollar was getting pummeled, investors were warned about the rise of single-country ETFs.

The concern was that these niche ETFs would wind up dominating more-diversified funds and splinter such a fast-growing market into near oblivion for long-term investors.

Now, a new leader has emerged, in leverage. And that has brought up the same concerns.

Last year, inverse ETFs aiming to provide 200% and 300% performance cleaned up. Consider that all but one of the top 20 ETFs in the past 12 months are built to short their indexes. The lone exception is the Vanguard Extended Duration Treasury Index ETF (NYSE: EDV).

More to the point, 15 of those 19 were using 2x or 3x inverse coverage to heighten returns in a strongly downward market. The remaining four single inverse (-100%) funds didn't have any amped-up competition.

In the past month, as markets have strongly rebounded, leveraged ETFs have moved into the forefront. The Direxion Daily Financial Bull 3x Shares (NYSE: FAS) is the leader with a better than 60% return during that time frame. In fact, the only two nonleveraged ETFs to make it into the top 10 have been the Market Vectors Indonesia ETF (NYSE: IDX) and the Rydex S&P SmallCap 600 Pure Value ETF (NYSE: RZV).

Rapidly Changing Landscape

The problem with using souped-up inverse and leverage is that if you're right, you can become a hero. But if you're wrong, you can become a real goat.

And that doesn't just apply to deciding between short and going extra long with your funds. You can get whipsawed within the same fund very quickly, no matter whether it's of the inverse or leveraged type.

Take for example what would've happened if you were to have bet on the Ultra Russell MidCap Value ProShares (NYSE: UVU). In the latest rally—now entering its sixth week—you would've made more than 30%. But if you held it during the course of the past year, you'd be down close to 70%.

By comparison, if you had bought the nonleveraged iShares Russell Midcap Value Index (NYSE: IWS), your gains in the past month would've only been around 20%. But your losses in the 12 months could've been pared nearly in half.

 

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