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Beware the leveraged and inverse ETFs! May 4, 2009

Posted by shaferfinancial in Finance, Uncategorized.
Tags: , ,

Read this article about the leveraged ETFs from Morningstar.

Basically, these instruments were designed for day trading by large institutional money managers to hedge some risk.  But they have gotten very popular with retail investors trying to leverage up their bets.  No problem there, but the real issue comes in the math of how these index funds work.  You can actually guess right, but lose money as a result of long term holding of these!

The math is what I have warned about in other situations.  Average returns hide the reality of the ups and downs of any index.  When you are calculating daily, as these indexes do, it compounds the problem with down days.  You lose 10% the first day and gain 10% the second day and you have an average return of 0%.  So you are even right?  Wrong you are down 1%  ((100 X -.1) + (90 X 1.1) = 99.  You start with a hundred dollars and lose 10% you have $90.  The next day you gain 10% and you have $99 for a $1 loss.

Long term holding of these products exasperate the problem and do end up with skewed results to the negative!

Heed the warning if you are considering this type of investment.



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