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By Jason Stipp | 04-06-2011 09:00 AM

Is There a Right Way to Use a Leveraged or Inverse ETF?

Morningstar's Paul Justice explains why these ETFs don't perform the way many investors expect, even though they are working as stated.

Jason Stipp: I am Jason Stipp for Morningstar.

It's ETF Investing Week on, and today we are answering your ETF questions.

I'm talking with Paul Justice; he is director of North American research for ETFs. He's going to talk about leverage and inverse funds. These are funds that created a few headlines recently about whether they are good investments at all. We're going to ask today, is there any use for these funds and how can you use them in a smart way, if you are going to use them?

Thanks for joining me, Paul.

Paul Justice: Thanks for having me.

Stipp: So, you folks talked about these funds at length recently, talked about why you have to use them carefully and why they perform in ways that people don't expect.

Before we talk about how you might use these in a smart way, can we talk about these investments don't perform the way people expect them to perform and why people get into somewhat of a trap with them because of the way that they are using them?

Justice: Sure. Well first, you can look at the data: Any leveraged ETF that's been around since Jan. 1 of 2008 or before has a loss, and there were 23 up funds and 23 down (inverse) funds. So, for all those to have a loss, there has got to be some sort of issue going on if indexes are going to move in any direction. That issue is a volatility drag: Whenever there is volatility in the market, which we had heightened volatility for a long period of time, it will cause both double-long and double-short funds, potentially, to lose money, no matter which way the index goes.

So, that's an issue that people need to aware of. It's an expectation error, where they see this phrase of two times or ... three times long or short, and they expect that, no matter when they purchase that fund, when they sell it, if it's one day or one year later, they have this mentality, they expect to get that multiplier. That's not the case at all. You look in that fund's prospectus, and it defines what kind of timeframe you should get that exposure.

Stipp: So, the timeframe is important because these funds do say that they are going to do an inverse, they do say that they are going to give double exposure. Do they actually deliver it over any time period then?

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