3 Factors to Consider Before Buying Leveraged and Short
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
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
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
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