MONEY ETFs

The ETFs You Should Never Buy

Leveraged funds that amplify the market's returns can quickly—and unpredictably— magnify risks in your portfolio.

Larry Fink, the CEO of giant asset manager BlackRock, said at a recent investment conference that a kind of exchange-traded fund called leveraged ETFs “have a structural problem that could blow up the whole industry one day.”

BlackRock runs iShares, a leading ETF manager. ETFs are funds that can be traded like stocks, and they are great, low-cost tools for investing in indexes such as the S&P 500. Leveraged ETF also tracks indexes, but add the twist of magnifying gains or losses. So, for example a “2x” leveraged ETF might aim to deliver twice the return, up or down, of the S&P 500.

iShares does not run leveraged ETFs. So you can discount Fink’s remarks as at least partly a broadside against the competition. He was also arguing that regulators should focus on specific products, rather than on the size of a money manager — a good point to make when you run $4 trillion, as BlackRock does.

It’s unclear exactly what system-wide risk Fink is saying such funds pose. That said, this much is true: For individual investors, leveraged ETFs are a no good, terrible, very bad idea.

The key thing about leveraged ETFs is that they deliver their leverage on a daily basis. You might assume that if, say, the market falls 5% in a year, a 2X leveraged fund might lose 10%, and if the market rises 5%, the 2x fund would gain 10%. But in fact the returns could be quite different over time, especially in a volatile up-and-down market.

Fund companies that sell leveraged ETF’s disclose this, but the effect of daily leverage is a subtle point some individual investors looking for a more aggressive investment might miss. The Securities and Exchange Commission, by way of cautioning investors, provides an example of how this works, which we’ve turned into charts.

Start with a big down day in the markets. One ETF just follows the market index, while another delivers twice the gain or loss. The effect is predictable:

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The next day, the market goes back up. The regular fund rises 10%, and the levered fund rises 20%.

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Both funds did what they were supposed to do each day. But look what happens when you add up the effects of two days of trading.

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The index lost $1, but your twice leverage fund lost four times as much.

Daily leverage can be useful to professional investors. Other forms of leverage can be useful to individuals with long-run goals. But few individual investors are likely to be successful with the kind of short-term market timing these funds are built for.

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