Basics of Leveraged ETFs
Do you prefer a hand saw or a chain saw? It probably depends on the job. It’s not that one is better than the other; they are just different tools for different jobs. The same is true with ETFs and leveraged ETFs, or (leveraged) short ETFs. One isn’t superior to the other, but there are distinct differences. Broad market index ETFs like the S&P 500 SPDR (SPY) or Dow Diamonds (DIA) are solid investment ‘tools’ similar to a hand saw.
“Leveraged ETFs and leveraged short ETFs are like high octane power tools,” says Simon Maierhofer, founder of iSPYETF. “They can get a job done quickly, but they also can do quick damage to any portfolio.” There is a reason craftsmen wear safety gear when using power tools. Investors looking to buy short or leveraged ETFs should also invest in ‘safety gear’ in the form of education.
The structure of leveraged (short) ETFs can (and likely will) cause performance distortions not expected by the average investor. To attain the leverage needed to deliver two or three times the performance of the underlying index, the leveraged ETF will invest in options, futures and swaps. While ETF providers generally know what they are doing, certain risks inherent to options, futures, and swaps, are simply out of their control and will inevitably be passed on to ETF investors. Other tracking risks are simply caused by the daily leveraging effect. Know the ETF basics before investing.
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