Are Leveraged and Short ETFs Right for You?
By Ron DeLegge, Editor
June 24, 2009

SAN DIEGO (ETFguide.com) – Exchange-traded funds (ETFs) that attempt to magnify their gains and to provide inverse market performance have become the financial services industry’s punching bag. And it’s not hard to see why.

After amassing billions of dollars of investment over a very short time frame, leveraged and short ETFs have become the envy of Wall Street.

Just three short years after launching its first series of specialized ETFs in 2006, ProShares have accumulated over $26 billion and is the now the fifth largest U.S. ETF provider of assets. A similar trend is seen with other companies within this emerging space.

Direxion Shares launched its lineup of leveraged ETFs which offer daily triple magnification just seven months ago and already has almost $5 billion under management. It’s no wonder leveraged and short ETFs are being targeted by everyone from failed stock pickers to aggressive financial regulators. Success doesn’t just breed criticism, but jealousy! 

The main question for investors is this: What role, if any, should leveraged and short ETFs play inside your portfolio? Are these types of specialized ETFs right for you?

It’s a good idea to consider these three issues before making any moves:

Your Time Horizon
If you have a very short investment time horizon of a few weeks or even just a few days, then leveraged and short ETFs could be right for you. That’s because the investment objective of virtually all leveraged and short ETFs is to achieve short-term investment results that correspond to the daily inverse or daily magnified performance. Let’s analyze one example.

The Direxion Daily Financial Bull 3x Shares (NYSEArca: FAS) attempts to deliver three times the DAILY performance of financial stocks within the Russell 1000 Financial Services Index. If this particular benchmark increases in value by 1% on any given day, FAS tries to obtain a 3% gain. But remember, leverage is a double-edged sword that can cut your pockets wide open. If financial services stocks decline by 1% on any given day, FAS as its designed should fall by 3%.

Investors that want to bet on the long-term gains or losses of a particular asset class or industry sector should not be using daily leveraged and short ETFs. It’s that simple. The next iteration of these funds might be better suited for investors that have an intermediate time horizon. Product developers are already working on ETFs that attempt to achieve magnified performance returns over longer time periods, not just daily.

Your Level of Risk Tolerance
A careful assessment of your own willingness to tolerate risk is crucial to your money along with your sanity. You should do this before you invest money, not afterwards. Always ask questions first. Once you’ve gotten a satisfactory answer, then you can shoot, not the other way around.

This point was made in a June regulatory alert sent to financial professionals by the Financial Industry Regulatory Authority, also known as “FINRA.” In part they stated, “It is important that members (brokers and advisors) make every effort to familiarize themselves with each customer’s ability to meet the risks involved with such products.” If you’re thinking about investing in leveraged and short ETFs or already own them, have you completed your self-examination?

Your Investment Goals
Any investments you decide to buy should always be compatible with your ultimate investment goals. If you’re an income oriented investor, for example, it would make little sense if the vast majority of your investments consist of growth investments which produce little or no income.

Always make sure the investments inside your portfolio match your goals. This is true for any type of investment, leveraged and short ETFs included. 

Conclusion
While critics of leveraged and short ETFs often argue these products are creating market imbalances, they conveniently skip the subtle but important details. For example, how can ETFs that short financial stocks like the ProShares UltraShort Financials (NYSEArca: SKF) be the culprits for falling share prices when leveraged ETFs that are long financial stocks like the ProShares Ultra Financial (NYSEArca: UYG) have their short counterparts outsized by almost two-to-one?

Certain ETF providers have already moved to increase product disclosures and other safety nets. Direxion Shares recently changed the name of its entire lineup of leveraged and short ETFs to reflect the word “Daily.” This was a leadership by the Boston, MA-based fund company designed to help investors clearly understand that Direxion Shares attempt to deliver daily leveraged and inverse returns of their underlying indexes.

Because Direxion has been the only ETF provider in this category to take corrective action to properly label its financial products, it’s this author’s view the Securities and Exchange Commission (S.E.C.) should force ProShares, Rydex Investments along with other providers of leveraged and inverse ETFs and ETNs to insert the word “Daily” into all of their product names. How much longer will financial regulators allow the use of mislabeled financial products? Shame on ProShares, Rydex and the others for not taking corrective acting.

In the meantime, you should examine the entire spectrum of key factors along with your own financial situation before you’ve convinced yourself that leveraged and short ETFs are right for you.