Leveraged exchange traded funds have gained popularity in the past five years as they provide investors a means to hedge, speculate and invest in the post 2009 “bull market.” But the risks lurk just under the surface, and when the inevitable market correction occurs, these products will likely be remembered as ticking time bombs, mutual funds for the millennial generation.
Leveraged ETFs use financial derivatives to model and then multiply the returns of an index like the S&P, the price of silver or even the real estate market in China. Futures contracts and swap agreements rather than any physical assets allow the funds to “lever up” and produce outsized returns or losses.
In addition to the risks of using leverage to multiply returns, as pure derivatives using futures contracts to generate returns, leveraged ETFs are a decaying asset. Every day the fund is open is another day that the intrinsic value of the underling derivative contract decreases. This means that holding a long term position means holding on to an investment that loses value everyday, mitigated only by a price increase due to investor sentiment.
FINRA has discussed the risks of using leveraged ETFs in regulatory notice 09-31 and in subsequent memos