Warren Buffett, John Bogle and Jeremy Siegel all recommend it; that is, many superheroes of the investing universe advise the "little guy" to buy-n-hold index funds. And for these heroes… you should hold through thick, thin, down, up and sideways.

Regular readers and money management clients know that I have a different "take." I believe that you buy good stuff with an intention of holding your investment. And when, for whatever reason, your good stuff is no longer maintaining its "goodness", you sell. You make sure that every investment choice that you’ve ever made is either a big gain, small gain or small loss… but never a big loss. (Check here for more on the wisdom of avoiding a big loss.)

Yet, let’s say that you’ve bought into the buy-n-hold mentality. You accept the notion that you simply keep buying in good markets and in bad markets because… eventually… stocks go up over the long run.

With that belief in tow, then there "seems to be" little reason to avoid leveraged ETFs. You have those that seek to deliver twice (2x) a broad market benchmark like the ProShares Ultra S&P 500 (SSO). Others may drill down into style, such as the "double-the-midcap-growth index fund," the ProShares Ultra Mid Cap Growth Fund (UKW). Still others seek to leverage economic segments where the ProShares Ultra Materials Fund (YUM) seeks 200% of the Dow Jones U.S. Basic Materials Index.

Again, if you are buying stock indexes for the long haul, wouldn’t you double your returns by selecting an investment that gives you 2x that index? No-brainier… right?

Well… not exactly. An understanding of compounding and "bear market math" makes buying-n-holding a leveraged investment downright dumb.

Let’s first illustrate with actual returns. Nearly 2 years ago, on June 21, 2006, the ProShares Ultra S&P 500 (SSO) began to trade. The S&P 500 has gone from 1290 to 1425 through May 16, 2008 and the S&P 500 SP DR Trust (SPY) that tracks its progress is up 18.5% (adjusted for dividends).

A semi-logical assumption might be to assume that the Ultra S&P 500 (SSO) would have gained 36% in this period… double the index. However, this investment is actually up a bit less than the unleveraged fund, at approximately 18%, also adjusted for dividends. (See the chart below.)


The easiest way to understand discrepancies between leveraged and unleveraged investment results is by doing a little "bear market math." For instance, let’s say that an unleveraged energy fund and a leveraged energy fund are both trading for $50. You purchase the leveraged ETF. The energy index soars out of the gate like Big Brown at the Preakness, 10% higher to $55 in a matter of weeks. Even better, your leveraged investment has rocketed 20% straight to $60.

Ahhhhhhh… but the world energy markets hit a major oil slick. The unleveraged energy index slips 25% from its $60 highs, and now trades at roughly $41. Yet the leveraged investment falls 50% from its peak, and now trades at $30. You are now down 40%!

Now let’s say that energy recovers its winning ways… and it gains a handsome 25% off of its unleveraged $41 bottom. The unleveraged index investor has recovered losses, and sits a bit above his/her purchase price at approx $52 for a 4% gain.

What about the leveraged index investor? He/she gets a phenomenal 50% gain off the $30 price, and winds up at $45. He is still down with a -10% return!!!

Matt Hougan for IndexUniverse has done extensive research on leveraged ETFs. His findings suggest that twice leveraged investments will deliver no more than 130-150 per cent of an index return over the long run. Worse yet, if you run into a bear, the effects of volatility, negative compounding and "bear market math" could destroy your portfolio.

Does this suggest that investors should avoid leveraged ETFs altogether. No… but buy-n-holders should definitely stay away.

We could easily see a 15-year cycle where the Dow trades as high as 20,000 and as low as 7,500, ending up at Dow 10,000 in 2015. The buy-n-holder of unleveraged ETFs will at least break even, whereas the buy-n-holder of leveraged vehicles may suffer negative returns that he/she would be unable to recover from. (It’d be like trying to rebound from Nasdaq-like 80% losses.)

On the flip side, investors who have a plan to sell will recognize profits in 3 or 4 bull markets during the hypothesized 15-year cycle. And when the bearish downturns come, he/she can avoid the bulk of it by realizing small losses. Nobody needs to hold through a bear.

You can profit in leveraged ETFs. I made a suggestion near the March bottom to bet against the doom-n-gloomers. I suggested that that aggressive traders look into the unloved Ultra Financials (UYG) and the unfairly crucified tech sector with Ultra QQQ ProShares (QLD). (And I also made a point of telling ultra-aggressive traders to plan on selling!)

Similarly, I talked about shorting the consumer services sector in September 07 with great success. Once again, I made the suggestion ONLY in the context of having a plan to sell.

Leveraged ETFs can work well as a trader’s tool. They can also work well for protecting positions (long or short) without having to sell. But they are more likely to hurt buy-n-holders than help them.

Disclosure Statement: ETF Expert is a web log ("blog") that makes the world of ETFs easier to understand. Pacific Park Financial, Inc., a Registered Investment Advisor with the SEC, may hold positions in the ETFs, mutual funds and/or index funds mentioned above. Investors who are interested in money management services may visit the Pacific Park Financial, Inc. web site.

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