Morningstar Solutions
ETF Solutions
Handle with Caution: Leveraged ETFs
Slide 2: Handle with Caution: Leveraged ETFs
One of the fastest-growing segments of the ETF industry are leveraged and inverse ETFs. These funds use large dollops of leverage to gain additional exposure to the market (for example, twice the return of the S&P 500), short a segment of the market, or both. While leveraged and inverse ETFs may seem like exciting investment tools, it is important to understand how these ETFs work before you jump in.
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Slide 3: Handle with Caution: Leveraged ETFs
Leveraged and inverse ETFs are NOT meant to be held as long-term investments. Very bad things can happen whenever you hold these ETFs longer than their indicated compounding period (typically one day for stock-based ETFs, sometimes monthly for commodities), and you are almost mathematically guaranteed to get a return that is not double that of the index. In fact, the longer you hold one of these funds, the probability that you will get nothing close to double the returns increases. Not only will the magnitude of your returns bounce around, you might not even get returns that are in the same direction as the changes in the index.
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Slide 4: Handle with Caution: Leveraged ETFs
Identifying an actionable investment thesis (i.e., stocks look cheap) is difficult enough. Trying to also predict the exact timeframe over which your idea will become reality is even more difficult. Finally, actually detailing the path--knowing how volatile the daily price swings will be and in which direction--is nearly impossible.
Slide 5: Handle with Caution: Leveraged ETFs
If you intend to hold leveraged or inverse funds beyond their compounding periods, you'd have to be right on all these factors to get double the index's return. In other words, when employing leverage and compounding returns, predicting how the investment will perform is only part of the challenge. You also have to correctly predict the path the investment is going to take.
Slide 6: Handle with Caution: Leveraged ETFs
If you're hell-bent on using leverage for any period of time longer than a day, you'd be better off using a margin account in almost any real-world scenario. This is not an opinion--it's a highly likely statistical probability. And interestingly enough, each successive time you bet against the odds, probabilities tend to become mathematical facts.
Slide 7: Handle with Caution: Leveraged ETFs
These funds can be used for short-term speculation. If you're inclined to bet--not invest--as to what a sector or index is going to do over the course of a day or two, go ahead and use these funds. Good luck. We've never met an investor who can consistently execute this strategy.
Slide 8: Handle with Caution: Leveraged ETFs
In our view, these products should be viewed as hedging and speculation tools that are better suited for use by professional investors. For instance, an institutional investor seeking to hedge his exposure to oil could theoretically do so by using one third of the capital. The investor could then deploy the extra capital afforded to him by the 300% in other investment opportunities. The leveraged inverse ETFs can make sense from a risk management perspective as well: An investor can't lose more than his or her initial investment with these products, while in a traditional short position one would theoretically be exposed to unlimited losses.
Slide 9: Handle with Caution: Leveraged ETFs
One final factor to consider before delving into these aggressive products is tax efficiency. In order to meet their objective of amplified daily returns on their respective benchmarks, these ETFs enter into swaps and other derivative contracts. These contracts are "marked to market" every day and the ETFs are taxed on a "look-through" basis (meaning the investor is taxed as if he or she had owned the underlying securities that the ETF invested in). Therefore, investors owning these products can expect to be hit with short-term capital gains tax rates when they decide to sell--regardless of how long the investment was held.
Slide 10: Handle with Caution: Leveraged ETFs
The bottom line is that these aggressively leveraged products are not particularly attractive as long-term investments. However, we do concede that there are sophisticated investors out there who will appreciate the financial flexibility afforded by the leverage these types of ETFs provide. We simply suggest that these extremely volatile securities be kept on a tight leash.
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Handle with Caution: Leveraged ETFs
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