Opinion and Investing Column

Kim: Steer clear of leveraged exchange-traded funds

August 31, 2013

KimIf you are confident the S&P 500 will be 20 percent higher a year from now, wouldn’t it be great if there were a way to magnify that gain for yourself?

You might think an exchange-traded fund (ETF) whose objective is to provide two times or even three times the return of the S&P 500 would be just the ticket to earn 40 percent (two times) or 60 percent (three times).

You couldn’t be more wrong. Even if your prediction of a 20-percent gain comes to fruition, there is almost zero chance the ETF will return 40 percent or 60 percent. In fact, depending on how bumpy the path was during the S&P 500’s year-long journey to a 20-percent gain, your ETF could actually end up with a loss.

Shares of mutual funds and ETFs both represent interests in a portfolio of securities. For a mutual fund, a closing net asset value is calculated and shares are purchased or redeemed at that single price.

The SPDR S&P 500 Trust launched in January 1993 as the first ETF. The “Spider” was the first S&P 500 index fund whose shares both fluctuated in price with the underlying securities and traded on an exchange during the day. ETFs exploded in popularity by offering investors the ability to gain exposure to a broad or narrow sector of the market quickly and efficiently.

Alas, as often happens on Wall Street, product development wizards came up with a way for investors to “juice” their returns by creating “non-traditional” ETFs. These ETFs enable investors to place magnified, directional bets. In other words, thanks to issuers like Direxion and ProShares, you can place a magnified bet (leveraged ETFs) on an index or sector, either up or down (inverse ETFs).

What most investors fail to realize is, unlike buy-and-hold mutual funds or ETFs, leveraged ETFs are designed to be held no longer than one day. Their stated objective is to provide two times or three times the return of an index or sector (or its inverse) for a single day. They create this magnified exposure by using a combination of securities, including swaps, futures contracts and other derivative instruments.

It’s important to note that a leveraged ETF rebalances its positions so it starts each day with exactly its stated two times or three times exposure. The upshot is, if you hold a leveraged ETF longer than one day, your return is not two times or three times the return of the index or sector for the period; it is the product of the series of daily leveraged returns for the ETF.

It’s surely confusing, but there can be a huge difference. A holder of a leveraged ETF in a volatile market can be whipsawed by the fund’s daily rebalancing.

Indeed, the SEC and Financial Industry Regulatory Authority issued an alert in 2009 that described inverse and leveraged ETFs as “highly complex financial instruments” that “typically are unsuitable for retail investors who plan to hold them for longer than one trading session, particularly in volatile markets.”

Stay away from inverse and leveraged ETFs. If you want to gamble, go to a casino. If you can accurately predict which way stocks are headed, over what time frame and the daily volatility, you should be writing this column.•

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Kim is the chief operating officer and chief compliance officer for Kirr Marbach & Co. LLC, an investment adviser based in Columbus, Ind. He can be reached at (812) 376-9444 or mickey@kirrmar.com.

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