ktrotter79 (99.92)

4 reasons not to buy leveraged ETFs!

January 24, 2009 – Comments (4) | RELATED TICKERS: SSO , QLD , BGZ

1. Many investors are misled by these leveraged ETFs and believe that they’ll get twice the daily return of the underlying index over the long term. In other words, if the index returns 10% next year, they’ll get 20%. But doubling a string of daily returns is not the same thing as doubling the annual returns, so investors should not expect that level of performance, unless they somehow rebalance their portfolios every single day.

2. Even just looking at X2 funds as a theoretical concept, the idea has some problems. The only way for a fund to maintain a constant leverage ratio is to buy shares whenever prices go up and then sell them when prices go down. This buying and selling activity increases the underlying volatility, and can lead to huge sell-offs in down markets that are impossible to recover from in the next bull market. This effect can be seen in every leveraged fund that went through the 2000 to 2002 downturn.

3. The current ETFs do not even deliver twice the daily performance of the underlying index. In just the nine months that the products have available, a lag has emerged between theoretical and actual performance. This lag is 3.3% for the SSO and 6.4% for the QLD. Given this lag, we could extrapolate that over several years, these funds would greatly underperform their theoretical X2 counterparts and at some points, even the underlying indexes. Note that a lag is unavoidable because of interest costs.

4. Investors should compare these new ETFs to the leveraged funds that were offered by these same companies seven years ago, because the long-term performance will most likely be similar. These funds were hit hard during the downturn and never really recovered during the next bull market.

I want to make it clear that I am not saying that leveraged indexing is a bad idea. I think that they have tremendous potential. The underlying concept, borrowing cheaply to make long-term investments in a total stock market index, is based upon both solid historical data and Nobel-prize winning academics.

But until new products are available, based upon the short-term results of SSO and QLD, the long-term results of the leveraged funds, and the mathematical pitfalls of constant leverage, I would suggest that investors avoid holding these leveraged ETFs as investments. If a leveraged indexed investment is desired, the best solution is still call options, index futures, or conventional index ETFs held in a margin account.