Leveraged Exchange-Traded Funds: Suitability

Leveraged exchange-traded fund products are not suitable for all investors and should be viewed as hedging and speculation tools that are better suited for use by professional traders, who have the desire and ability to monitor and trade their positions daily. In most circumstances, investors would be better off adjusting their asset allocation rather than placing a risky and expensive bet in a leverage product.

Trader beware

In order to provide the exact multiple over a longer period of time would require daily trading, or dynamically hedging one's portfolio much like other complex financial instruments such as options. For an institution that is able to do that, leverage products may provide some benefits. For instance to hedge an exposure to an index using a 3x-levered product could be done with one third of the capital. The leveraged inverse ETFs can make sense from a risk management perspective as well: An investor can't lose more than his or her initial investment with these products, while in a traditional short position one would theoretically be exposed to unlimited losses.

Consider the tax issues

One final factor to consider before delving into these aggressive products is tax efficiency. In order to meet their objective of amplified daily returns on their respective benchmarks, these ETFs enter into swaps and other derivative contracts. These contracts are "marked to market" every day and the ETFs are taxed on a "look-through" basis (meaning the investor is taxed as if he or she had owned the underlying securities that the ETF invested in). Therefore, investors owning these products can expect to be hit with short-term capital gains tax rates when they decide to sell—regardless of how long the investment was held.