Don't rush to buy leveraged exchange traded funds

Take a look at the funds page of the business section of your newspaper (assuming you still use a print newspaper, and it still has a business section). You're likely to notice funds with names that include the word "Ultra" or "3X" appearing in the leaders and laggards tables. Those funds (traditional mutual funds as well as exchange-traded funds), and others like them, are known as leveraged funds. In 2015, at least 235 leveraged ETFs were available to investors.

Leveraged funds are designed to amplify the returns of a particular index or commodity. In the case of a triple-leveraged, or 3X Standard & Poor's 500 Index leveraged, fund, for example, a 1 percent daily gain in the S&P 500 will result in an increase of 3 percent. Such funds accomplish that amplification by trading a combination of stocks, futures contracts, and other derivatives.

But don't go rushing to your broker to buy a leveraged ETF. In practice, leveraged funds and ETFs present problems for the buy-and-hold investor. One of the problems that we often cite is cost. All of those derivatives that leveraged funds trade to meet their investment objectives cost much more to operate than an index-tracking ETF. The average leveraged ETF sports an expense ratio of 0.94 percent––many times more than the cost of broad market index ETFs.

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In addition, leveraged funds don't pay the same dividends that most stock ETFs do. That can be a big drawback: Dividends provide almost half of a stock investor's total return over the long run. Currently, S&P 500 investors receive a 1.9 percent dividend yield, vs. 0 percent for many leveraged ETFs.

And over periods longer than a day, leveraged funds tend to deviate from the index tracked because of compounding of returns. The more volatile the market, the more likely a leveraged ETF will lose ground. When the S&P 500 fell 37 percent in 2008, for example, the leveraged ProShares Ultra S&P 500 (ticker: SSO), designed to double the daily return of the S&P 500, lost 68 percent. Over the next two years, as the market rebounded, the unleveraged investor had almost recovered from the 2008 losses. But the ProShares investor was still down more than 40 percent.

Sum all of those factors, and it's no longer a surprise that sometimes a leveraged ETF won't provide the sort of gains expected. While the SPDR S&P 500 ETF (ticker: SPY) recently returned 4.3 percent over a six-month period, the Direxion Daily S&P 500 Bull 3X ETF (ticker: SPXL) returned only 9.4 percent over that same span—not the 12.9 percent that the math suggests.

––Chris Horymski