Some clients may be tempted by the enticing potential gains of leveraged ETFs, which can double or even triple market performance.
But most advisors urge clients to stay away from leveraged ETFs and their cousins, inverse ETFs, unless they have a very specific, and most likely, very short-term strategy.
“You’ve got to be extremely careful with leveraged ETFs,” says Jerry Slusiewicz, principal of Pacific Financial Advisors in Laguna Niguel, Calif.
“Those should be only used in very specific circumstances, because they’re a double-edged sword,” he says. “You can make more money, but you can also lose money twice as fast or three times as fast.”
Slusiewicz doesn’t think of leveraged ETFs as ordinary, long-term investment vehicles.
“Leveraged and inverse ETFs are for a different type of trader, a different type of animal, a different type of investor,” he says.
The only time Slusiewicz uses leveraged ETFs is for a short-term hedge or for quick exposure to a special opportunity, and even then, he always goes to extreme lengths to make sure that the client, no matter how experienced, understands the risks.
For example, he might consider an inverse ETF if a client doesn’t want to sell a portfolio but is worried about a market decline. In that case, the strategy may reduce risk.
“But I only do that for short periods of time, because I either lift the hedge or start selling off the equity side if I’m in an actively managed fund,” Slusiewicz says.
One problem is that leveraged and inverse ETFs use derivatives, says Tim Maurer, a CFP and the director of personal finance at Buckingham Asset Management and the BAM Alliance in Charleston, S.C.
Derivative-based ETFs often don’t respond to market stimuli in predictable ways, resulting in unpleasant surprises, he says.
“I don’t believe that the evidence suggests that the utilization of derivatives adds value long term to investors,” Maurer says. “I’m not suggesting that there aren’t ways to utilize derivatives, even if it’s only for hedging purposes, but I believe that ETFs that use derivatives get people -- investors and even advisors -- in more trouble than they benefit them.”
Maurer is also leery of the market-timing element inherent in leveraged ETFs.
“If you’re talking about going two times or three times a benchmark, then you’re talking about a strategy based on market timing; there’s no way around that,” he says. “Since I don’t believe that market timing is effective, then I’m not going to believe that instruments that utilize the strategy are effective.”
Additionally, using leveraged and inverse ETFs starts to work against some of the built-in benefits of ETFs, such as low costs, Maurer says.
“You’re not likely looking at an ETF that has a very low expense ratio if it has two times the gain, or an inverse, because it requires more effort on the part of the manager,” he says.
Paul Hechinger is a contributing writer for On Wall Street.
This story is part of a 30-30 series on smart ETF strategies.