Be Cautious With Leveraged ETFs

9/19/2011


Up 70.2% year-to-date, Direxion Daily 20 Year Plus Treasury Bull 3x ($59; TMF) is this year's best-performing exchange-traded fund (ETF). It's also not your typical Treasury bond fund, as it relies on leverage to juice returns and is too risky for most bond investors.

Nearly 230 ETFs employ leverage, which can provide potentially higher returns at the cost of increased volatility. In general, to achieve the desired leverage, ETFs invest all or a portion of their assets in derivative securities, such as swaps or futures.

Leveraged funds generally seek to provide returns that double or triple the performance of a benchmark. For example, each $1 invested in the Direxion fund provides $3 of exposure to the performance of the underlying benchmark, which roughly translates to 300% of the return and volatility.

While many ETFs use leverage to benefit from market rallies, another type — the inverse ETF — moves in the opposite direction of its benchmark. For example, an inverse fund seeking a negative return of two times its index should gain roughly 2% on a day its benchmark declines 1%.

Importantly, leveraged ETFs are designed to magnify the returns of their benchmark for a single day. Issuers rebalance most of these portfolios daily. Thus, performance over periods longer than one day can differ in amount — and even direction — from the target index because of the compounding of daily returns.

So far in 2011, the S&P 500 has lost 5.4%. ProShares UltraPro S&P 500 ($51; UPRO), designed to return triple (300%) the daily performance of the index, is down 24.8%. Interestingly, ProShares UltraPro Short S&P 500 ($19; SPXU), which seeks to triple the inverse of the index, is down 2.1%.

Leveraged ETFs are intended for short-term traders, investors looking to hedge a portfolio, and those who actively monitor their positions. Long-term investors and those who can't stomach the potential for sizable losses should avoid leveraged ETFs.

RECOMMENDED MUTUAL FUNDS

Through Sept. 13, our recommended Growth Portfolio has lost 6.9% so far this year, versus a 7.3% loss for its benchmark portfolio. The Conservative Portfolio is down 4.7%, versus a 4.2% loss for its benchmark.

— Year-to-Date —
—– % of Portfolio –—
Fund (Price; Ticker)
Return
(%)
Rank
Conser-
vative
(%)
Growth
(%)
Fund
Rating
American Century Heritage
($19; TWHIX)
(5.7)
B
6
7
63
Buffalo Growth
($23; BUFGX)
(6.6)
D
10
11
82
Dreyfus MidCap Index
($26; PESPX)
(6.8)
B
0
0
82
Dreyfus Small Cap Stock Index
($18; DISSX)
(8.5)
B
0
0
62
Heartland Select Value
($26; HRSVX)
(10.0)
C
4
6
66
Heartland Value Plus
($26; HRVIX)
(11.7)
c
5
6
94
Manning & Napier International
($8; EXITX)
(12.4)
B
7
7
93
T. Rowe Price New Horizons
($32; PRNHX)
(1.3)
A
7
7
98
Vanguard 500 Index
($107; VFINX)
(5.5)
B
5
5
67
Vanguard Dividend Growth
($14; VDIGX)
(1.2)
A
10
11
99
Vanguard Emerging Mkts.
Stock Indx. ($26; VEIEX)
(14.6)
C
0
4
90
Vanguard GNMA ($11; VFIIX)
6.6
B
10
5
91
Vanguard Inter.-Term Tax
Exempt ($14; VWITX)
7.4
B
0
0
75
Vanguard Short-Term Invest.
Grade ($11; VFSTX)
1.8
B
7
6
70
Vanguard Total Bond Mkt. Index ($11; VBMFX)
6.3
A
10
0
64
Vanguard Total Int'l Stock
Index ($13; VGTSX)
(13.8)
C
4
4
93
Vanguard Wellesley Income
($22; VWINX)
3.8
A
0
0
98
Vanguard Wellington
($30; VWELX)
(2.8)
B
6
9
83
Wasatch International Growth
($19; WAIGX)
(7.3)
A
4
6
96
Wells Fargo Advantage High
Income ($7; STHYX)
1.1
A
5
6
63
* Year-to-date ranks through Sept. 13 from Morningstar, comparing performance among funds with same objectives. A = top 20%; B = next 20%; C= middle 20%; D = next 20%; E = bottom 20%. Fund ratings are percentile ranks based on our fund-rating system.

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