You’ve probably heard about leveraged ETFs designed to deliver twice or even three times the return of their benchmarks however, before you put a penny into any such investment vehicles, you need to know exactly what you’re getting into.
The comments above & below are edited ([ ]) and abridged (…) excerpts from the original article by Ron Rowland (moneyandmarkets.com)
The good news is that leveraged ETFs almost always do what they’re designed to do. The bad news is that way too many investors don’t understand what these ETFs are designed to do — and expect more than the fund sponsors ever promised to deliver.
How Leveraged ETFs Work
What people don’t understand about leveraged ETFs is that the 2x or 3x leverage factor can change dramatically, depending on how long you own the fund. That’s because the leverage is reset every day which means that even if a leveraged ETF’s benchmark moves sideways, its value could still melt away like butter in a microwave oven.
Over time, the result can be a huge mismatch between what you think you should get and what you actually do get. In nearly every case, the long-term performance of both the long and inverse versions of leveraged ETFs will underperform their benchmark indexes. Why is this? It’s the magic of compounding at work, only this time it’s working against you.
Every day you hold one of these ETFs, your leverage factor drifts a little bit away from where you started at 3x and if it moves in the wrong direction, suddenly you have to dig yourself out of a hole. Typically the difference isn’t much on any one day but if you stay in the position for long, the difference will be dramatic — especially if the market you’re trading makes a big swing.[Investing in leveraged ETFs is all about] how aggressive an investor you are, and how much confidence you have in your ability to time the markets. Bottom line – leveraged ETFs can be great but you must use them correctly!
Leveraged ETFs are mainly intended for short-term trading and by short-term, I mean a few days at most. Stick around any longer and the results will start to vary wildly. Indeed, the Financial Industry Regulatory Authority, or FINRA, has warned brokers that leveraged ETFs are too risky for investors who intend to hold for more than one day. Unfortunately, most stock brokers don’t understand how leverage works, either.
If you’re a day trader — someone who watches the market minute-by-minute and closes out your positions every evening — then leveraged ETFs can be a great tool. They can also be useful over longer periods if you know what to expect and watch your ETFs like a hawk, or if you have someone trustworthy watching them for you.
I highly recommend you take some time to educate yourself on these ETFs before you use them on your own.
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