Leveraged exchange-traded funds, originally viewed as tools for fast-moving day traders, are showing up more frequently as buy-and-hold investments in Mom and Pop portfolios, thanks to the advisors who are putting them there.
These funds, which exist across several asset classes, magnify the moves of their underlying indexes by delivering twice or three times their return. Some had a particularly good showing in 2013, when the Standard & Poor's 500 index rose almost 30 percent. The Direxion Daily S&P 500 Bull 3x Shares ETF, for example, gained 118.9 percent in 2013, more than triple the S&P 500's gains.
Advisors like New York-based Matt Blank have taken note. Many of his clients have been holding the ProShares UltraShort 20+ Year Treasury ETF for a while, some more than six months. He has used that ETF, which aims to deliver twice the reverse of the Barclays Capital 20+ Year U.S. Treasury Index, for what he calls an "insurance policy" in case the fixed-income portion of his clients' portfolios sinks. That fund is up about 5.3 percent from a year ago, but it hit a year-to-date low last Monday, after tumbling 7.7 percent from two weeks prior. The fund is now down 9.5 percent year-to-date.
The number of registered investment advisors using leveraged and inverse ETFs - instruments that seek to deliver the opposite return of an index - has increased roughly 15 to 20 percent over the last year, according to Michael Eschmann, who heads product development at Direxion Shares, a Newton, Mass.-based ETF issuer with some 51 of the funds. Typically, advisors like this work with clients who do not day trade, and who would hold the ETFs in their clients' portfolios for far longer than the minutes or hours the Wall Street trader typically holds a position.
Eschmann said starting in late summer of last year he began getting calls "pretty frequently" from investors inquiring about longer holding periods.
That raises some concerns among those who fear that unwary investors could get slammed if they are sitting in a leveraged ETF at the wrong time.
"I think the warning about 'be careful when you're playing with matches' is appropriate here," said Joel Dickson, a senior investment strategist at Vanguard. "There's still a huge misunderstanding and gap in knowledge" among many investors.
Leveraged ETFs do magnify their index movements on a daily basis, but not necessarily over the long term, which can really foul up investors who buy at the wrong time or fail to sell. That is because these funds magnify losses as well as gains, and over time, that can push investors into a hole that is hard to climb out of.
A fund that goes up 30 percent one day and down 30 percent the next day ends up almost 10 percent below its starting price, for example. If it starts by going down 30 percent on the first day, it would have to go up roughly 42 percent to get back to its starting price. That compounding effect often results in the failure of leveraged ETFs to track their indexes over longer time periods.
Consider this example: The VelocityShares 3x Long Natural Gas ETN tracks three times the daily returns of the S&P GSCI Natural Gas Index Excess Return Index, an index that was very volatile in late January. That volatility produced sharp swings in the ETF.