V KThere is a tremendous misconception that leveraged (double, triple, long or short) ETFs are to be used as long-term investments. On the surface they make a lot of sense. You want to hedge your stock portfolio, for instance, you buy a double short ETF of the market SDS (double short of S&P 500) or QID (double short of Nasdaq 100) and for each 1% decline of the market you make 2%. It does sound like a great deal. Leveraged ETFs have been sold as panacea to this market volatility, but panacea they are not. If used as investment (not trading) vehicles they may cause a lot of harm to your portfolio even if you were “right” on their use. They should not be used as a long term investment, but only for short-term trading (i.e. days not months).

Daily compounding (recalculation) will cause their returns to deviate substantially from the underlying index. The math is too complex and too boring (an article by Morningstar explains it well), but instead let me demonstrate by this very real example (chart here).

Let's suppose that six months ago you had a great insight that financial stocks would decline. You figured to get bigger bang for the buck you’ll buy a double short of Dow Jones Financial Index (a simple plain vanilla long ETF for this index goes by symbol IYF). The index and thus IYF declined almost 20% in six months thus you’d expect your double short (SKF) would be up about 40%. However, if you look at the chart  you’ll see that it declined almost 60% instead, as much as double long ETF (UYG) of the same underlying index.

Note that over the short term (days) these ETFs seem to work. This is one of those investments where you have to make sure that you nail the timing perfectly, otherwise you are in trouble.

Marlowe Cassetti comments:

I have been both an ETF junkie as well as a mechanical trading system developer. Why not combine the two? I have found trading systems that operate on a basket of ETFs tend to suffer from the inclusion of the leveraged ETFs into the basket. This leads me to infer that the leveraged act more randomly then their cohorts. With that knowledge I was confronted with my system picking UltraUltra-Short Estate ProShares (SRS). I held my nose and bought it anyway and turned a nice 8% profit in two days, all the time watching it with high anxiety.


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