Are Leveraged ETFs Ever Right for Retail Investors?

Rachel Koning Beals

Who are leveraged exchange-traded funds and single stock ETFs meant for?

A glance at the Nasdaq volume rankings shows certain leveraged ETFs among the most actively traded issues on any given day -- broad market and financial sector funds in particular.

The benefits of leveraged ETFs certainly appeal to some groups of traders and investors because they're seen as an efficient way to expand upside potential or short the market. Plus, they offer exposure to specific market segments, commodities, and more, sometimes for less cost than mutual funds or individual stock buying.

Leveraged ETFs allow investors to gain additional exposure to the market (for example, twice or three times the return of the S&P 500), to short a segment of the market, or do both. Inverse ETFs are designed to replicate the opposite direction of these same indices, often at a multiple. These ETFs typically use a combination of futures, swaps, short sales, and other derivatives to achieve these objectives.

But the sudden and ongoing growth of these investments, and what regulators see as misuse among retail investors, prompted stern warnings from the Securities and Exchange Commission and the Financial Industry Regulatory Authority (FINRA). Fund family ProShares and others, which have been named in investor lawsuits over results, maintain that risk disclosures have "always been accurate and complete" and "complied with all legal requirements."

[Check Out A Beginner's Guide to Understanding ETFs.]

The answer, then, to what audience these investments are best suited for, depends largely on an investor's level of sophistication and time horizon. By design, leveraged ETFs are meant to be held for a day.

"These instruments are designed to be used as daily hedging and trading vehicles, but investors are holding them much longer than a day, which is particularly dicey in today's volatile markets," says columnist Howard Gold, at www.howardgold.com.

Noted traders and authors Chris Kacher and Gil Morales, at virtueofselfishinvesting.com, use sophisticated timing models for their market entries and exits. For them, tools like leveraged ETFs allow them to efficiently capitalize on both upside and downside market moves.

At the least, interested investors should spend an extended period tracking this market segment. Examples of leveraged ETFs that track the broad indexes are Ultra QQQ ProShares ETF (symbol: QLD); Ultra Dow 30 ProShares ETF (DDM); and Ultra S&P 500 ProShares ETF (SSO). Their relatively high volume can offer a snapshot on overall short-term market performance even if investors don't invest in the ETFs themselves.

[See How to Ride Out Market Swings With Low-Volatility ETFs.]

Investors may also notice come across exchange-traded notes (ETNs), which are the ETF equivalent in the fixed-income market. ETNs are structured investment products that are issued by a major bank or provider as senior debt notes.

Growth has also taken hold in leveraged commodities funds and those that offer international market exposure. In a recent SEC filing, Direxion, which is known for three-times returns products, filed a proposal for eight new funds focusing on the industrials sector along with gold and silver miners. The filing also included Direxion's plans to expand geographically, including a bull-bear pair of international ETFs offering exposure to Turkey.

"While it may be tempting to use a leveraged or inverse exchange-traded fund to capitalize on an investing idea or as a hedge, investors would probably be better served by using unleveraged products or adjusting their asset allocation," says Morningstar ETF analyst Michael Rawson.

One aspect investors may not be taking into consideration is the relatively higher cost of doing business with leveraged ETFs. For example, the Direxion Daily Small Cap Bull 3X Shares (TNA) charges an expense ratio of 1.03 percent per year, which puts it among the more expensive ETFs. It is in line with the cost of its rival ProShares fund. The fee is lower than most specialty bear-market mutual funds, however.

Rawson says the complexity of leveraged products makes them unattractive to most investors.

He says an outlook for a particular segment that calls for "leverage" can be achieved by taking a larger position in an unleveraged and liquid fund such as iShares Russell 2000 Index (IWM) or iShares S&P SmallCap 600 Index (IJR).

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