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Leveraged ETF Investing: More Risk With More Reward

October 25, 2009 by Guest Blogger

The word “leverage” gets some people excited, while it makes others nervous. No surprise since it’s just a word that represents “higher risk, higher reward”. Our contributing writer, Tim Parker from Elementary Finance, talks about leveraged ETFs and how you can use them to spice up your investment portfolio.

What Is Leverage?

I’d like to bring up a word that you may not use much: Leverage. Here’s a fairly simple definition: leverage refers to multiplying something you already have. I have legs that allow me to move — but I can “leverage” the speed of my movement by traveling in some sort of vehicle. For instance, I can get somewhere faster by riding an airplane. I can get to where I’m going in a fraction of the time this way.

But if I want to fly faster using a device (on my own) that can leverage my speed, I’m going to have to learn how to use that device. Trying to fly a plane without the sufficient knowledge to operate it can certainly be a huge risk and a dangerous endeavor; doing so would just be plain foolish.

Fun ICanHasCheezburger photo.

The same thing is true when you try to use leverage in the field of finance. We all have heard that it takes money to make money, and on the surface, it’s true. Let’s take for example the case of a typical part time retail investor who would probably invest, at the most, $2,000 into one stock position. Given historical long term stock market returns, it would be realistic to think that he could make 10% or so with his investment on an annual basis. A 10% return on his stock position yields around $200. That is certainly nothing to sneeze at but it isn’t going to change anyone’s standard of living, at least not until that 10% return multiplies itself many times over.

Now here’s the thing, there are many ways to multiply that return many times over — you can go on margin with your investments, but it’s something that takes a tremendous amount of risk, which to me, boils down to making a gamble. There’s also the “wait and see” (or buy and hold) approach: over time, investments go up in value in a market uptrend, their returns multiplied as a consequence of the power of compounding. But if you aren’t necessarily interested in borrowing from your broker in order to purchase securities (via margin) but you feel that you can afford to take on some risk to give your portfolio that extra nudge, then there’s a way to leverage by simply relying on the right stock picks you make.

By using a little money to make a lot of money, you’ll be able to “leverage” what you already have. This is possible with a type of exchange traded fund called a leveraged ETF. Let’s look at one of my favorites:

Leveraged ETF Investing: More Risk With More Reward

The ProShares Ultra Dow (DDM) is a leveraged exchange traded fund that moves at twice the rate of the Dow Jones Industrial Average. If the Dow moves up 1%, this ETF moves up 2%. If the Dow has a great day and moves up 3%, you’ll make 6% in one day! Quite a nice way to invest, isn’t it? Here is a tidy list of Ultra ProShares Leveraged ETFs that tracks the whole spectrum of indexes (and more):

But wait — let’s not forget the risks! In the world of investing, investment rewards are directly proportional to the risks that you take. Let’s not forget the dark side to this. If the Dow moves down 3%, you’ll lose 6% of your investment. While these leveraged ETFs have the ability to make you a lot of money, they also have the ability to double or even triple your bad decisions, and will magnify your risk. You should only use these ETFs if you have a proven history of good stock picks or if you can afford to lose the money that you put into these funds.

One other aspect about these ETFs that isn’t publicized is this: leveraged ETFs are best for day trading. If you are not a day trader, you probably should steer clear. The reason for this is something that we aren’t going to talk about in great detail, but here’s the gist: ETFs are rebalanced at regular intervals, with most of them being rebalanced each night. You would expect that if the Dow goes up 10% over 3 weeks, your investment in DDM would make you 20%. But that’s not the case due to rebalancing. For that reason, you should aim to sell these ETFs at the end of the day.

Here’s the bottom line: leveraged ETFs are a great tool for using a little bit of money to make a nice profit, but they can also sharply magnify a bad decision that can lead to great financial loss. Don’t let greed lead you to experience big losses. Be careful, dear investors!

We’d love to hear from those of you who’ve invested in and traded leveraged ETFs. Being new-ish financial products, these ETFs may not be widely traded, so it would be interesting to hear about anyone’s experiences with such funds.

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