Stay away from leveraged mutual funds and leveraged ETFs!

I just read a good article at ‘Seeking Alpha’ on the dangers of leveraged mutual funds and ETFs (Exchange-Traded Funds.)  A leveraged fund is one that uses fancy sercurities like derivatives and options to double or triple the daily returns of an index (like the S&P500, for example.)  However, this does NOT actually double (or triple) the total return for several reasons.

1) Constant rebalancing: Leveraged funds must buy more stocks when markets go up in order to maintain a certain ratio of leverage to investment (1:1 for a ‘double’ fund.)  Similarly, in down markets these funds must sell off their investments.

This creates a large amount of trading (read: transaction fees) and short-term capital gains (read: taxes.)  If you don’t know already, rapid active trading is a dumb investment strategy because the fees and taxes eat away your potential gains.  (You’re better off buying and holding broad, low-fee index funds, or an ETF of that index fund.)

2) Interest payments: All that debt that leverage funds use doesn’t come free.  These funds pay interest and fees to use fancy securities, which comes straight out of your pocket.  As you can see in the article I mentioned above, this results in woeful underperformance in bear markets (= market going down), with only slight overperformance (of the underlying index) in bull markets (= market going up.)

I would bet that over the long-term, these funds & ETFs will underperform the market, or at least not come close to making up for their huge risks and volatility with increased return.  Instead of looking for a get-rich-quick scheme by leveraging to the hilt, look at much better places to put your money.

Bottom Line: Stay away from leveraged mutuals funds and ETFs, they could be hazordous to your wealth!

(As an aside, I should note that the idea of leveraging (slightly) an index for the long term is not altogether a bad thing, and may be helpful if done in the right way.  However, the current set of leveraged ETFs and mutual funds that take on monster leverage and result in high fees and constant trading are BAD.  That’s not to say that an individual investor couldn’t use index funds in a margin account or other options (that the Seeking Alpha author suggests) to use leverage intelligently.  However, that’s a topic for another day, and one that I really don’t think anyone reading this needs to be worried about.  As of today, I use NO leverage in any of my financial securities (= stocks & bonds) investments.)

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