Leveraged ETFs spilt the opinions of the ETF community. Some love them, others hate them. One thing is for sure, leveraged ETFs are powerful tools with the potential to make you rich or poor,in a hurry. Here are a few lessons that will help you avoid getting creamed.
Do you like fine cars? The BMW M6 has become the dream car for many. The epitome of German engineering comes with a dual power setting. A mysterious power button that sits in the center console, offers the instant gratification to boost the engine’s power from 400 hp to 507 hp.
You may wonder what that has to do with ETFs. In short, leveraged ETFs are the BMW M6 of investing. With or without a power button, those ETFs offer high octane performance.
While BMW’s M6 can zoom you from point A to point B in a hurry, you may also find yourself wrapped around a tree if you’re not careful. Leveraged ETFs, just like the M6, can rack up profits at high speed, but can also crash your portfolio in no time.
Driving a fast car is fun, and investing with leveraged ETFs can be also, as long as you follow a few simply rules and guidelines; consider them your road signs. Don’t worry, there are no investment cops, but the market may punish you nevertheless, if you don’t follow the rules.
A look under the hood – the basics
Leveraged (long) ETFs intend to deliver 2x or 3x the daily performance of the underlying index. Short ETFs intend to replicate 1x, 2x, or 3x the daily inverse performance of the underlying index. Short component delivers the opposite or inverse performance of the index, whereas the leveraged feature magnifies the performance of the underlying index
Example: leveraged (long) ETFs
To illustrate, let’s take a look at a suite of leveraged ETFs. The objective of the Ultra S&P ProShares (NYSEArca: SSO) is to deliver 2x the performance of the S&P 500 (NYSEArca: SPY), while the Direxion Large Cap Bull 3x Shares (NYSEArca: BGU) aim to deliver 3x the performance of large cap stocks, as represented by the Russell 1000 Index (NYSEArca: IWB), there is no triple leveraged long ETF linked to the S&P 500.
In a perfect world, SSO will gain 2% if large cap stocks are down by 1%, while BGU would gain 3%.
Example: (leveraged) short ETFs
On the other end of the spectrum, the Short S&P 500 ProShares (NYSEArca: SH) aim to deliver the opposite daily performance of the S&P 500. The UltraShort S&P 500 ProShares (NYSEArca: SDS) aim to deliver twice the opposite daily performance of the S&P 500, while the Direxion Large Cap Bear 3x Shares (NYSEArca: BGZ) aim to deliver triple the opposite daily performance. A 1% loss in the S&P 500 would (ideally) translate into a 1% gain for SH, a 2% gain for SDS, and a 3% gain for BGZ.
In addition to Direxion, ProShares, and Rydex, PowerShares and Van Eck offer ETNs linked to various commodities and currencies.
Lesson #1: Respect the leverage
If you are looking for a way to make or lose 60% in a few days, double or triple leveraged ETFs are the solution. The Ultra Real Estate ProShares (NYSEArca: URE), and its leveraged short cousin the UltraShort Real Estate ProShares (NYSEArca: SRS), can fluctuate 25% and more on any given day.
Such leverage needs to be respected and used responsibly. Buying a leveraged (long or short) ETF at an inopportune time can set your portfolio back real quick. Timing is a key component for investing in general, and investing in leveraged ETFs in particular. More about how to get the timing right in a moment.