New ETF Offers Leverage and Pitfalls

Other fixed-income instruments besides a money market fund might allow for higher yields. A well-timed 10-year Treasury purchase -- and by well-timed, I mean, "when the yield curve is steeper and there is some visibility for lower rates" -- could increase the yield considerably.

There are plenty of people who would find this concept appealing. Of course, many investors try to beat the market by more than 2%. The bigger takeaway here is about capturing the market in different ways. The above strategy, which I obviously did not invent, allows an investor to capture the market with less capital directly exposed and with the flexibility of having half the portfolio in cash.

The flip side of the leverage coin is a type of trade where investors get in trouble with leverage. Imagine buying ProShares Ultra S&P500 or any of the other double-long funds on full margin (yes, it's marginable), thus capturing four times the move of the market. But under this scenario, a 5% drop in the S&P 500 would result in a 20% drop in your account.

How It Couldn't

Back to the flies in the ointment, which I believe could extend to all the entries in this series of leveraged funds from ProFunds: The fee of 0.95% will not be a huge drag when the market has a big move, but in a year when the market is up single digits, the fee could be noticeable.

The bigger issue is the potential tracking errors. As money comes and goes from the fund, cash builds up temporarily for one reason or another. Distortion in the markets where the fund executes its trades, and perhaps some other reasons, will make trying to game the tracking error difficult to impossible for the managers, probably yielding some degree of disconnect between the fund and the index. Every strategy has flaws, and for my money, this potential tracking error is the biggest flaw in precise execution of this concept.

It makes sense to think that a similar product will be available one day on a foreign-equity benchmark like the MSCI EAFE index. This would open the door to more diversification with the flexibility of a large cash position.

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Please note that due to factors including low market capitalization and/or insufficient public float, we consider ProShares Ultra S&P500 fund to be a small-cap stock. You should be aware that such stocks are subject to more risk than stocks of larger companies, including greater volatility, lower liquidity and less publicly available information, and that postings such as this one can have an effect on their stock prices.

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