Leveraged ETFs: Comprehension Is Key

The controversy surrounding ultra long, ultra short and other leveraged ETFs has reached a fever pitch while the funds, particularly the Direxion Financial Bear 3x ETF(FAZ Quote) and Direxion Financial Bull 3x ETF(FAS Quote), continue to grow in trading volume.

While leveraged ETF funds are not a new phenomenon, they have hit the mainstream and have drawn the attention of regulatory agencies like FINRA and commentators asserting that investors should be protected against these products. Like all financial tools, the power of leveraged ETFs is truly in the hands of the investor, and the danger lies in an investor's unwillingness or inability to understand them.

Quite often investors don't get what they expect when investing in ultra long or ultra short ETFs and are confused when, over time, their fund fails to track the objective that is advertised. In a Wall Street Journal article, Paul Justice, an ETF specialist for Morningstar(MORN Quote) recently noted that Since most leveraged ETFs "reset" each day, it is difficult to gauge long term returns; twice the daily return of an index is not twice the monthly return.

"When employing leverage and compounding returns, an investor would have to know how volatile and in which direction the daily price swings will be--which is nearly impossible--to know how he will fare beyond one day," Justice said.

This encapsulates the complex nature of the leveraged funds and the way in which alternating market currents can erode leveraged funds over time. Examples of this include the widely traded FAS and FAZ. Even though the two are opposite and track three times the Russell 1000 Financial Services Index, both funds are down year-to-date. The bear fund, FAZ, is down 85% year-to-date, according to FactSet Research. The bull fund, FAS, is down 67% in the same period.