Trick or Treat? Leveraged ETFs…

Leveraged ETFs…these two words will evoke passionate debate at any investment gathering! Many investors are split about whether these products are a trick by ETF providers or a treat. The truth is that leveraged ETFs aren’t that different from most consumer products. As long as you follow the directions and don’t misuse the product, the results will be consistent and as advertised.

Unfortunately, leveraged ETFs aren’t the most intuitive product for investors to use right out of the box. They take some reading, explaining and in some cases mathematical tutoring. However, once you understand concepts like compounding, volatility and magnification, leveraged ETFs are actually quite mundane. Here are a few tips to keep leveraged ETFs from turning into tricks on your portfolio.

As with any ETF, one must first understand the index the ETF tracks. This is done be reviewing the index methodology in the prospectus. The index methodology outlines the beginning universe the final portfolio is derived from as well as the factors involved in the selection of the portfolio, the weighting scheme and the rebalance schedule. Understanding the index methodology allows investors to match their investment thesis or needs with the appropriate product. For example, if you wanted to invest in a broad based China ETF, you would want an ETF that tracks an index that contains as many sectors of the economy as possible instead of one that may be concentrated in two or three sectors. A quick review of index methodology will determine the correct product for the investment parameter.

Second, and perhaps most importantly for leveraged ETFs, it’s crucial to examine and confirm the direction in which you’d like to invest. Do you want to go long and be a bull or go short and be a bear? While this is elementary, there are a variety of times investors have made the error of purchasing a leveraged ETF in the wrong direction! This is usually attributed to ticker symbol confusion. Although leveraged ETF families have fairly well defined naming conventions be sure to go the extra mile and double check the ticker matches the appropriate fund name and the direction of your trade.

Third, the magnification level of the ETF needs to be examined. There are a variety of options that are available: 1x, 2x and 3x in some cases. Each level of magnification creates more volatility and thus should be carefully matched with the individual investment scenario.

Finally, the target time period needs to be considered for any leveraged ETF. The target time period is the targeted amount of time the fund is using to produce the leveraged returns. The majority of leveraged ETFs target a one day period but there are some funds that target a monthly period. The shorter the period targeted the more likely it is that these products will have to be managed and or traded in order to deliver the results expected. Leverage will reset each time period and thus volatile markets can significantly alter returns for an investor who buys and holds a product longer than the target period. My advice for most investors is to not hold these products longer than their target time period. Consult the prospectus to determine the time period, then invest accordingly.

Leveraged ETFs are one product that investors MUST read a prospectus before use. They are not intuitive products but once they are understood can be a nice compliment — or treat — to many portfolios.

Here are quick links to education centers from the two leading leveraged ETF sponsors, Proshares and Direxion. Also be sure to check out the leveraged ETF center at etfdb.com, a leading source of ETF related wisdom and guidance.