Should You Invest in Leveraged and Inverse ETFs?

Welcome back to this episode of The Winning Investor’s Quick and Dirty Tips to Beating the Market.  I'm your host, Andrew Horowitz.

We've been talking about exchange-traded funds during our last few episodes and I wanted to conclude this discussion with you by describing some of the exotic uses some traders and investors have for specialty ETFs.

We've discussed broad market ETFs, sector specific ETFs, international ETFs, commodity ETFs, and more...  but now let's talk about two riskier ETF categories known as inverse ETFs and leveraged or "juiced" ETFs.

What are Leveraged ETFs?

First, let's start with leveraged ETFs, which are easier to understand for most people.  Remember we discussed the ticker symbol SPY for the basket ETF for the S&P 500 Index.  If we felt very confident that the S&P 500 was going to rise in the short-term, we might want to get extra returns by trading on leverage/borrowing to invest.  To trade on leverage, or margin, we would have to meet the requirements our broker has to let us borrow money to invest money in the hopes we will get a quick return and then pay back the broker with interest.

However, we can just as easily purchase a leveraged ETF, which in this case would trade under the symbol "SSO"-- the ProShares Ultra S&P 500. This leveraged-ETF would be expected to return two times the percentage gain of the S&P 500!  The fund manager accomplishes this by using advanced investment techniques like futures, options, and other leveraged techniques to try for two times the return of the SPY ETF which seeks to mirror the return of the S&P 500.

Other popular leveraged ETFs would include the symbol QLD which would return 200% or two-times the Quad-Q's (QQQQ) which track the NASDAQ-100.  If you wanted to leverage the Dow-Jones 30 stocks or double the performance of the DIA - Diamonds, you would use ticker symbol DDM.

What are the Dangers of Leveraged ETFs?

The danger of a leveraged ETF -- of course -- is if you purchase a leveraged fund and then you start to lose money, or are wrong in your position.  You'll be losing money at twice the rate than had you purchased a standard ETF like the SPY!

In this business, we call "margin" a two-sided sword.  On one hand, if you're correct in your market call, you can make money quicker and faster... however, if you are wrong, you'll lose money just as quick and you'll be in a large losing position faster than you'll know what hit you!  That is why most people only invest in leveraged funds if they are experienced investors or want to take advantage of a very short-term speculative bet in the market.

You generally do not want to hold leveraged funds for the long-term because there are various tracking errors where long-term performance might not be what you would expect it to be.  Remember: only use leveraged funds for very short-term speculative plays because the risk is twice as high as normal funds.

ETFs to Short the Market

On the other side of the ETF scale are ETFs that allow you to "short" the stock market, a particular sector, or commodities without actually making you sell short anything.  These can be helpful in retirement accounts or portfolios in which there is a ban or restriction on short selling stocks.

Sometimes it can be hard to wrap your mind around what it means to “short sell” something, and we will discuss short selling in an upcoming episode, but for now, just know that if you short a stock, then you will make money when the stock falls in value.  It's sort of like buying in reverse, which is where you buy something at a low price and hope that it goes up.  When you short something, you sell first at a higher price and then hope to buy it back at a lower price later.

What Are Inverse ETFs?

However, all the complexity is simplified with inverse ETFs.  If you purchase an inverse ETF, and then the stock market falls, your ETF will rise, which gives you profits.

Take a look at the ETF symbol DOG which is the inverse Dow Jones Index, or inverse of ETF DIA.  When the Dow Jones Index falls, DOG will rise.  If you wanted to “short” the S&P 500, then you would buy the inverse ETF with ticker symbol SH.

Just remember that if you buy an inverse ETF and the stock market rises, then you will lose money in your position.  The same warnings that go with shorting stocks generally go with shorting ETFs as well.

We will come back later and talk more about shorting and whether or not it might be appropriate for you and your growing portfolio.

Keep with us as we discuss even more ways to become a winning investor in our next podcast! If there’s a question you’d really like to ask, just email me at winninginvestor@quickanddirtytips.com or call 206-338-0836. That’s 206-338-0836 and maybe your question will appear on the show.

And if you like the show, tell a friend or leave a review on iTunes. Until next time, this is Andrew Horowitz with The Winning Investor’s Quick and Dirty Tips for Beating the Market wishing you all the best on your quest to investment success.