Buyer Beware: Why Leveraged ETFs Are Dangerous (QLD, QID, PSQ, IXG)

The rapid rise of ETF volumes have proved a boon for the retail investor. ETFs make it easy to make a play in a specific sector, without the hassle of investing in a mutual fund or buying multiple stocks. For example, if an investor wants to bet on financials, he or she can just buy the iShares S&P Global Financials

. Nothing beats the feeling of correctly making a prediction about the market and smiling about it all the way to the bank. If an investor wants to bet, say, the NASDAQ composite will drop, how would he go about doing that? A hedge fund would make the bet by constructing complicated positions with options and derivatives. Everyday retail investors would not have the knowhow to construct a bear spread, so they had no way of placing bets like these. That is, no way until ETFs came along and provided an answer.

Nowadays, betting the NASDAQ will fall is as simple as buying shares of ProShares Short QQQ

. Feeling really confident? Buy a leveraged ETF. ProShares UltraShort QQQ

is designed to return 2X the inverse of the NASDAQ. (If the NASDAQ falls 1%, QID rises 2%.) Leveraged and inverse ETFs provide great tools for trading shops and day traders,

.

Leveraged ETFs are designed to return a multiple of the

return of an index. The keyword here is "daily". Here is a simple numerical example: NASDAQ is at 2000. QLD

, designed to yield 2X the daily return of NASDAQ, is at $50. Day 0 - NASDAQ 2000, QLD 50.00 Day 1 - NASDAQ 2060 (up 3%), QLD 53 (up 6%) Day 2 - NASDAQ 1998.2 (down 3%), QLD 49.82 (down 6%) Day 3 - NASDAQ 2058.15 (up 3%), QLD 52.81 (up 6%) Day 4 - NASDAQ 1975.82 (down 4%), QLD 48.58 (down 8%) Day 5 - NASDAQ 2001.51 (up 1.3%), QLD 49.84 (up 2.6%) In this example, the NASDAQ barely budged, ending the week up 0.075%. But counterintuitively, QLD ends the week DOWN $0.16. No, it is not due to a rounding error. You can check the math yourself.

The problem is compounding. A leveraged ETF guaranteeing a multiple of a daily return

guarantee a multiple of the return over a year, month, week, or even two-day period. And the larger the index moves, the more the problem gets exacerbated. Day 0 - NASDAQ 2000, QLD 50 Day 1 - NASDAQ 1800 (down 10%), QLD 40 (down 20%) Day 2 - NASDAQ 1980 (up 10%), QLD 48 (up 20%) Here, the NASDAQ is down 1% over 2 days, but QLD is down 4%. Or even more exaggerated Day 0 - NASDAQ 2000, QLD 50 Day 1 - NASDAQ 1000 (down 50%), QLD 0 (down 100%) Day 2 - NASDAQ 2000 (up 100%), QLD 0 (up 200%) God forbid the NASDAQ ever lose half its value in one day, but this example shows how exposed you are to volatility when investing in leveraged ETFs. The NASDAQ ends the two-day period dead even, but you just lost all your money. All these "UltraShorts" and "Bull 3X's" may sound like they are giving you a multiple of an index's return, but these returns are

, not long term. The bigger the multiple, the bigger the compounding problem gets (3X is worse than 2X is worse than 1.5X). Also, the longer the time period, the wider the gap between a leveraged ETF's "expected" return and actual return.

Not only are your long term returns not guaranteed to match the index, leveraged ETFs expose you to unneeded market volatility. Unsurprisingly, one of the worst periods for ETFs was late 2008, when the markets were going crazy (3-5% daily swings), and all leveraged ETFs suffered due to compounding. The takeway from all this, is that leveraged ETFs are not for the long-term investor. ETFs are great for quant shops, hedge funds, and day traders, but they are poison for Grandpa's pension fund.