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Top ETF Stories of 2009: Leveraged Funds

Stocks in this article: FAZ FAS

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.

Until just recently, the biggest problem with leveraged ETFs was that most retail investors didn't appreciate how leveraged funds were designed to work or the dangers involved in trading them. When ETFs were introduced they brought a refreshing level of transparency to the marketplace and to every day investors. ETFs are associated with low fees, passive strategies and transparent portfolios.

As the ETF industry has grown, however, increasingly complex products have been introduced. Many investors still associate these complex products with the initial, easy-to-grasp index ETFs that jump-started the ETF world. This is the difference between matches and a blowtorch -- both will start a fire, but they will do it in very different ways and to very different degrees. The distinction would be very important when telling someone which one to get.

This confusion, however, does not apply to just leveraged ETFs. Exchange-traded notes (ETNs), which are composed of debt instead of equity, were recently introduced into the ETF marketplace along with funds that use futures to track commodities like oil (USO) and natural gas (UNG). These funds should be put in a separate category from "regular" (stock index-based) ETFs. The acronym "ETN" is dangerously close to the word "ETF," and it is not surprising that new investors would assume that new ETFs play by the same rules as their predecessors.

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