3 Factors to Consider Before Buying Leveraged and Short ETFs
By Ron DeLegge, Editor
November 23, 2009

SAN DIEGO (ETFguide.com) – Exchange-traded funds (ETFs) that attempt to magnify their gains and to provide inverse market performance have become popular investment vehicles. Today, there’s around $30 billion invested in such products, up from just zero a few years ago.

What role, if any, should leveraged and short ETFs play inside your portfolio? Are these types of specialized ETFs right for you?

Here’s three factors to think about 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 Emerging Markets Bull 3x Shares (NYSEArca: EDC) attempts to deliver three times the DAILY performance of emerging market stocks within the MSCI Emerging Markets Index. If this particular benchmark increases in value by 1% on any given day, EDC tries to obtain a 3% gain. But remember, leverage is a double-edged sword that can cut your pockets wide open. If emerging market stocks decline by 1% on any given day, EDC 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 earlier in the year in a 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. 

Don’t Forget Taxes
One last important consideration is taxes. Because leveraged and short ETFs will typically own swaps and other derivative instruments instead of stocks and bonds, they aren’t very tax efficient compared to traditional ETFs. Last year, one short ETF stuck shareholders with a short-term gain of 86% of its net asset value (NAV)! Ouch!

Ideally, these products should be held in tax-deferred accounts, but if you already own a leveraged or short ETF in a taxable account and it’s enjoyed a huge runup, consider selling it ahead of its dividend record date. This will help to avoid getting stuck with a large tax liability. Lastly, if you’re thinking about investing in a leveraged or short ETF during the final part of the year, it’s smartest to delay your purchase until after tax distributions have been declared and paid. 

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.