It’s all too easy to be lured to the prospect of huge returns from leveraged ETFs with the ability to return double, and now, even triple the returns of particular sectors and indices. When looking back at the historical top performers in ETF lists, inevitably, the top slots are populated by leveraged ETFs. However, they’re risky for reasons that aren’t entirely obvious to retail investors. It’s not just the prospect that magnified performance can also mean magnified losses, it’s also the insidious value decay that occurs over time that sucks away value slowly, day by day.

How Leveraged ETFs Work

The most prominent leveraged ETFs are offered by ProShares and Direxion. Essentially, these ETFs will return 2X or 3X the DAILY return of the underlying benchmark (note daily, not over any particular term). On any given day, these ETFs do pretty much meet their claim. While there are higher than typical expense ratios and tracking error is inherent in any ETF, over a single day, if the S&P500 rises 1%, a 2X fund will rise 2%.

Leveraged ETF Time Decay

The problem arises when these ETFs are held over longer periods of time, even just a week or so. When there’s a sustained trend and you picked the right direction, that’s great for you. However, when the trend reverses or even if the trend is zigging and zagging, even though the underlying benchmark might be say, flat over time, the leveraged ETF loses money. And even worse, it’s quite common for both the long and the short leveraged ETF for a particular strategy to lose money.

Here’s how these daily return ETFs spell disaster over time:

• Example 3X daily return leveraged ETF

• Period is 2 weeks

• Underlying sector is volatile but ends up at the same value as day 1.

• Both Index and leveraged ETF have start value of 100 as a proxy

Day         Index % Move                      Index                       3X ETF
1                     -2                                  98.0                   94.0
2                    -3                                  95.1                    85.5
3                      4                                  98.9                   95.8
4                      5                                  103.8                  110.2
5                     -3                                 100.7                100.3
6                      -1                                 99.7                     97.3
7                        1                                  100.7                   100.2
8                       -3                                 97.7                      91.2
9                        4                                101.6                     102.1
10                  -1.5                              100.0                     97.5

As you can see, over just a 2 week period, while your underlying proxy may have been flat, you’ve already lost 2.5% (excluding the expense ratio) in a long 3X daily return ETF. Imagine what this looks like over months or years (virtually all leveraged ETFs are negative for the 1+ year period due to this phenomena). Unfortunately, many retail investors are simply unaware of this eventuality, regardless of how many tough the regulatory authorities have been on the companies and even given the companies’ disclosures.

Have I Ever Used a Leveraged ETF?

I’ve got to admit that I’ve used leveraged ETFs to exploit near-term trends that are too attractive to ignore. For instance, during 2009, when Treasuries were actually yielding negative (this has rarely happend in the history of the United States), I shorted Treasuries with leveraged ETFs with the conviction that this situation could not persist – and it didn’t. It was the easiest money I ever made. Additionally, I recently shorted the Euro during the Greek implosion by using the ETF (EUO) which is a 2X short Euro currency ETF. However, I closed the position quickly with a decent gain once the trend reversed and only held for a net 2 weeks. I knew that even if the Euro continued to decline, by holding EUO for months, I’d end up losing money either way. I’m not saying you’re not a “sophisticated investor” and I am, but I do want to emphasize the risk associated with leveraged ETFs so you’re not surprised when the time value decay creeps up in your investment account later.