Exchange-traded funds (ETFs) are arguably the biggest development in recent market history.
Today, the market landscape is smothered by ETFs. For investors, that is great news. You can invest in domestic stocks, foreign stocks, bonds, growth stocks, income stocks and even indexes at costs approaching zero.
But as with all good things, there are also some land mines that you should avoid.
There is one type of ETF that you should avoid at all costs unless you completely understand the nuances behind it. I am talking about leveraged ETFs.
These leveraged ETFs appear attractive at the outset. They promise anywhere from double to quadruple the returns of a directional move in their underlying securities.
Don’t fall for it.
Think about this for a moment…
If you could buy an ETF that promised double or triple the gains of the market depending on the direction, why not just buy it and hold it forever? It just doesn’t work that way.
These leveraged ETFs provide you with returns based on daily moves, not perpetual moves.
Let’s say you bought a triple-return ETF banking on the market moving higher. If the market moved up 5% one day, you would make 15%. If it moved down 5%, you would lose 15% that day. The next day, you would start all over again.
As you can see, you can make or lose a lot of money in a hurry.
Some investors find this prospect attractive… until the market moves in the wrong direction for a period of days or weeks.
These ETFs trade options – not stocks, which are tied to underlying moves on the indexes. Options, which I love to use, have a unique characteristic in that a large component of their value is based on time. That’s because they have a limited time frame. They expire.
Options lose time value as they get closer to expiration. That directly affects the prices of these ETFs. They lose value each day regardless of what the market does and must purchase new options on a regular basis to maintain their directional positions. That costs money.
Even if the market does not move at all, these ETFs will lose money daily because of this kind of “leakage.” This adds to the cost of owning the ETFs, which already sport some of the highest management fees in the market.
If you are an experienced investor with a lot of risk tolerance and money to “bet” on the market, then and only then should you even consider leveraged ETFs.
If you are sure that a short-term trend will continue for a few days or weeks, they are a good bet. But never, ever look at them as a long-term holding for your portfolio.