Exchange Traded Funds, or ETFs for short, take an investment that’s normally complicated and simplify it. ETFs make it easy for any investor to put money into a variety of macro ideas with one easy to buy share.

Take the popular ProShares ETFs. ProShares give you the opportunity to buy and sell the Dow, S&P, NASDAQ, Russell and more.  Overall, they mimic the price of these indices, minus a small fee or transaction cost.

And best of all, it’s an easy way to buy and sell trends through your usual broker or online account. No messy futures contracts, no complicated math — just a cheaper way to invest in the NASDAQ.

But what if I told you all ETFs aren’t created equally? And what if I told you that some ETFs might really hurt your overall ability to profit?

Today, I’ve got a word of caution for you: some of the funds you’re holding are destined to fail in certain market conditions. In fact, some are even planned to fail…

Let me explain…

The Double Long Danger

If you have ever invested in a double long or double short ETF, or even a triple long ETF, you might be setting yourself up for long-term disaster.

Here’s what I mean…

All ETF’s are created for a purpose. As I mentioned above, the popular index ETFs are used as a proxy for trading an up or down trend in an index. Using these Index based ETFs, you can speculate in the small-cap markets with Long/Short NASDAQ or Long/Short Russell, for example.

All of those “single long” ETFs are created to give you direct 1 for 1 exposure to your market of choice. And for our purpose today, those single long ETFs aren’t a danger since the risk associated with most broad based ETFs is minimal.

What I want to warn you about is a danger you might be unaware of in leveraged ETFs: double long, double short, ultra long and ultra short investment vehicles…

When most investors look at ETF’s, they look at them as safe bets. Investing in an ETF normally gets the same risk label as investing in a mutual fund. And for single long/short ETFs that may be somewhat true. But for more leveraged ETFs, like double longs/shorts, your long-term risk increases exponentially in certain market conditions.

A Real World Example of Double Long Disaster

Let’s assume that you (along with me) want to take advantage of the coming rise in the price of the NASDAQ. Well as you know there are plenty of ways to do that — but for this article we wont be talking about specific companies or growth opportunities. (If you want a fine list of those just ask my good friends Jim Nelson or Greg Guenthner, the editors of Penny Stock Fortunes.)

One great way to play the rise in NASDAQ prices would be a single long NASDAQ ETF. But with the arrival of double long ETFs wouldn’t making twice the gain on the index be better?

Maybe not.

You see, when it comes to leveraged ETFs, the proof is in the prospectus. These leveraged ETFs weren’t necessarily made for a normal buy and hold investor.

More specifically, these ETFs were made, for the most part, to mimic the leveraged outcome of daily movements. And for a long-term investor this could be a real anchor on your speedboat — especially in an up and down market.

Here’s the simplest example I can think of…

Let’s say you own a single long NASDAQ ETF, a double long NASDAQ ETF and a Double Short NASDAQ ETF. And let’s assume that you have a nice round $100 in each.

On the first day that you hold these ETFs, the NASDAQ rises 10%. Here’s what you’d have:

• The single long ETF would rise to $110
• The double long ETF would rise to $120
• The double short ETF would sink to $80

Pretty standard, right?  Well, here’s where it gets tricky…

Say the market now dips back down 10% the very next day…

• The single long ETF sinks to $99
• The double long ETF sinks to $96
• The double short ETF rises to $96

In an up and down market, leverage works against you. In other words, short-term volatility can eat away at any long-term gains. And if the market were to continue to oscillate, you would constantly lose money on leveraged ETFs. By day ten in the above example, you would have lost 4.9% in the single long ETF — but you would have lost a whopping 18.4% in both leveraged ETFs.

That’s a risk that you might not have known you were taking…all because some leveraged ETFs are planned to use daily movements. And if the market is especially volatile, keeping your money in a leveraged ETF could be financial suicide.

I’ll spare you the math of other examples (including dollar based examples instead of percentage based ones). But take my word for it — if you want to make double the action on the NASDAQ, it’s not as simple as buying the double long ETF.

Unless, of course, the NASDAQ never has a down day ever again…

Sincerely,
Matt Insley

April 28, 2009

Related Posts

• July 24, 2009 -- Why Actively Managed ETFs Are the Next Big Thing for Your Portfolio
• December 18, 2012 -- 3 Strong Sectors for 2013
• July 9, 2009 -- Is the Market Bound for Another Bottom?
• April 7, 2006 -- How to Be the Perfect Copycat
• January 14, 2005 -- Small-Cap Railroads: Sissies Beware

Matt Insley

Matt Insley is our in-house specialist in commodities and natural resources. He holds a degree from the University of Maryland with a double major in Business and Environmental Economics. Although always familiar with the financial markets, his main area of expertise stems from his background in the Agricultural and Natural Resources (AGNR) department. Over the past years he’s stayed well ahead of the curve with forward thinking ideas in both resource stocks and hard commodities. Insley is the managing editor of the Daily Resource Hunter and his commentary has been featured by MarketWatch.

View articles by Matt Insley