How to Double Your Trouble

If you are confident you picked the right horse, doesn't it make sense to double your bet?  Not necessarily, at least in the arcane world of investing in leveraged exchange traded funds (ETFs).  You can bet right on a leveraged ETF and still lose.  Not an attractive bargain.

ETFs seek to track the performance of a specific index or benchmark by holding a number of stocks or bonds.  Some ETFs mirror the broader stock market indices like the S&P 500, while others have a narrower focus, such as an oil and gas index.

A number of ETFs offer a chance to leverage your investment -- they claim that you can get 2 or 3 times the performance of the underlying index or benchmark.  So if you truly believe the price of oil is going up, you can pick an ETF that offers the promise of doubling or tripling your investment if oil rises.  Unfortunately, oil can go up and you can still lose on your investment.

As the Financial Industry Regulatory Authority (FINRA) points out, most leveraged ETFs "reset" daily -- they are designed to achieve their stated objective on a daily basis.  But over long periods of time, leveraged ETFs' performance can differ significantly from their objective due to the effect of compounding.

Thus, for example, in the first four months of 2009, the Dow Jones Oil & Gas Index gained 2 percent while an ETF seeking to deliver twice the daily return actually fell 6 percent.

The math that leads to this result is a bit hairy, but the basic concept is straightforward.  The result occurred because the oil index did not go straight up.  On some days, the index declined.  These drops in the index were also multiplied by two.  If the down days occur in an unfavorable pattern, you can make the right bet and still lose.  Volatile markets can magnify this effect.  (The same math also means that inverse ETFs -- those that promise positive returns when the underlying index declines -- also suffer from the same risks.)

Accordingly, FINRA concluded that "inverse and leveraged ETFs that are reset daily typically are unsuitable for retail investors who plan to hold them for longer than one trading session, particularly in volatile markets."

Buyer beware.

Words of Wisdom

The race is not always to the swift, nor the battle to the strong, but that's the way to bet.
-- Damon Runyon (wrote about gamblers and gangsters)