Understanding the Risks of Leveraged ETFs: Potential Pitfalls

While leveraged exchange-traded-funds (ETFs) offer an easy way to get more dramatic returns, they have real dangers that should be understood. A leveraged ETF is designed to produce returns that magnify the return of the underlying index by a factor of 2 or 3. Essentially, if the index goes up by 1%, a leveraged ETF will go up by 2 or 3%. In some instances, these instruments track the inverse of the underlying index-–they rise when the index goes down.

The most significant danger of these instruments is that over time the performance of the ETFs decays, much as an option's does. Because they try to provide the magnified return on a daily basis, in the long-run, the return is reduced. For example, if the S&P 500 drops by 1% on Monday and then gains 1% on Tuesday, the double S&P ETF will drop by 2% and then gain 2%. The larger move for the ETF means that it will fall behind, returning to 99.96% of its original value instead of 99.99%. Over time, leveraged ETFs tend to fall further and further behind, particularly when fees are included. Leveraged ETFs can be good trading instruments, but you should not use them as long-term investments.