Leveraged ETFs are one of the most controversial trading instruments to be introduced in recent years.
Many financial experts criticize leveraged ETFs as being too complicated and too risky for the retail investor. But leveraged ETFs are some of the professional trader's favorite tools -- and who doesn't want to be on the same side as the smart money?
Let's strip away all the commentary and criticism to explain exactly what a leveraged ETF is. Then you can decide for yourself if it's right for your portfolio.
Leveraged ETFs are meant to double, or in some cases triple, the daily performance of a particular index. Bearish leveraged ETFs attempt to deliver two or three times the inverse of the daily performance.
The way these ETFs accomplish their objectives is a big part of the controversy. They usually don't own or short stocks. Instead, they use options, swaps and other derivatives to deliver outsized returns.
Because leveraged ETFs are bundles of derivatives, investors cannot buy and hold them the way they do plain vanilla ETFs. Derivatives have a time value portion that decays as each day goes by. And because the leveraged ETF portfolio needs to be constantly rebalanced, expenses can really eat into investor returns. In fact, there are documented examples on the SEC web site of a leveraged ETF that produced negative returns even when the index it tracks moved up.
That's the bad news.
The good news is that when used properly, meaning over short-term time frames, leveraged ETFs can be a great tool for nimble investors who want to generate some quick profits. With that in mind, let's have a look at some of the most popular sector-specific leveraged ETFs.
Direxion Daily Financial Bull 3X shares (NYSE: FAS) & Direxion Daily Financial Bear 3x Shares (NYSE: FAZ)
Even if you're not intimately familiar with leveraged ETFs, you've probably already heard about FAS and FAZ. Both ETFs track the Wilshire 1000 Financial Services Index and both ETFs were front and center during the financial crisis that started in 2008.
FAS has an expense ratio of 0.85% and FAZ expenses check in at 0.95%, meaning neither are cheap by the standards of traditional ETFs. But both ETFs are highly liquid, averaging daily volume of about 77 million shares between the two of them.
Here's a great historical example of how powerful or problematic these ETFs can be: When the financial crisis reached its apex in late 2008, FAZ gained 65% from November 5 to November 18, while FAS lost 45% over the same period.
Ultra Oil & Gas Proshares (NYSE: DIG) & ProShares UltraShort Oil & Gas ETF (NYSE: DUG)
Got a feeling that big things are afoot in the energy patch? Then DIG and DUG are worth examining. Both ETFs track the Dow Jones U.S. Oil & Gas Index, which is home to major oil companies like Chevron (NYSE: CVX) and Exxon Mobil (NYSE: XOM) as well as some smaller, more obscure names. In total, the index is home to 92 stocks.
DIG and DUG are double leveraged ETFs, meaning that if the Oil & Gas Index moves 2% on a particular day, these ETFs should each move roughly 4%. Like FAS and FAZ, DIG and DUG are not cheap to own, with expense ratios of 0.95%.
The volatility that is seemingly always present in the energy sector can really drive some remarkable returns in short order with these ETFs. It would not be out of the realm of possibility to easily make 10%-15% in a single week with either DIG or DUG, and returns like that are just too compelling to ignore.
It may seem like ages ago, but in July of 2008, oil traded at $147 barrel before starting a precipitous decline. DIG lost -35% in 45 days, but DUG booked a 45% gain over the same period. An average gain of 1% per day is nothing to scoff at.
And if you're feeling particularly bold about the energy sector, try the Direxion Daily Energy Bull 3X Shares (NYSE: ERX) or its bearish partner, Direxion Daily Energy Bear 3X Shares (NYSE: ERY).
Ultra Basic Materials ProShares (NYSE: UYM) & UltraShort Basic Materials ProShares ETF (NYSE: SMN)
If you can stomach the volatility of energy stocks, then you may want to check out the materials sector as well. The phrase 'high beta' definitely applies to many of the most well-known materials names. UYM is essentially the leveraged counterpart to the iShares Dow Jones U.S. Basic Materials ETF (NYSE: IYM), which holds well-known stocks like Alcoa (NYSE: AA), Freeport McMoRan (NYSE: FCX) and Newmont Mining (NYSE: NEM).
UYM and SMN should deliver twice the daily performance of the materials index tracked by IYM. Both UYM and SMN have expense ratios of 0.95%, similar to other leveraged ETFs we've highlighted.
Materials stocks are known to be quite volatile, so be warned that UYM and SMN are going to ratchet up your risk profile. But the potential exists to garner some robust gains in short time frames.
Ultra Semiconductors ProShares (NYSE: USD) & UltraShort Semiconductor ProShares (NYSE: SSG)
If you're bullish on stocks like Intel (Nasdaq: INTC) and Texas Instruments (NYSE: TXM), USD is the way to go. In fact, USD actually holds positions in those stocks and several other chip makers, but also uses the same techniques as other leveraged ETFs to amplify returns.
Technology stocks aren't as volatile as energy or materials names, but the tech sector is one of the most widely followed industry groups in the market, meaning both USD and SSG can offer astute investors tidy returns. For example, in the two week period from April 15, 2010 to May 2, 2010, USD plunged an astounding 25%, but SSG soared 19%.
The ETFs we've explored here are a just a smattering of the leveraged ETFs currently on the market. There are also leveraged bullish and bearish ETFs that track the broader tech group, real estate stocks and consumer services names.
Approach all leveraged ETFs with caution. If you remember to keep your holding periods short, you may be able to lock in some exceptional gains.
