Why Leveraged ETFs Are Bad Investments

There has been an explosion of ETFs over the years and have been a viable option as opposed to traditional mutual funds. Lately, there has been an emergence of 2x and 3x leveraged ETFs as well. I myself started to dabble in trading a couple of ETFs to play the extremely volatile swings of the financial markets:

UYG (2x BULL)
FAS (3x BULL)
SKF (2x BEAR)
FAZ (3x BEAR)

While leveraged ETFs (in this case financial) are great trading vehicles, they are terrible investments. By investments, I mean, something you would buy for long-term.  Let’s take a look at the shocking diminishing returns of FAS.

FAS attempts to emulate triple the daily return of the RIFIN.X, the Russell 1000 Financial Services Index.  The closing prices of FAS and RIFIN.X on 2/6/2009 were:

FAS – $10.71
RIFIN.X – $533.61

Let’s assume RIFIN.X declines 3% or $16 to $517.61.  FAS would then decline 9% or $.96 to 9.75.

For this example, we’ll assume the Russell 1000 Financial Services Index corrects the next day back to where it was.  To do that, the index would need to increase $16, or about 3.1%, back to $533.61.

Well, if the index were to correct itself, then FAS must be the same.  WRONG! FAS would return 9.3% or $.90 for a closing price of $10.65, $.06 short of starting price in this scenario.

As you can see, after time the returns would continue to degrade on the leveraged ETF over time especially in a constant up/down market.  Other than the fees, leveraged ETFs would be great if the market would continue to have ‘up’ days (for bull ETFs) or ‘down’ days (for bear ETFs).

So use extreme caution when trading ETFs.  Don’t get caught up in the wild up days, because just as quickly, it can go down.  I’ve learned some valuable lessons, but in the end, I’ve done fairly well considering I didn’t grasp the concept until recently.

Stupidly Yours,

Matt

Source: Seeking Alpha
Full Disclosure: I currently hold UYG