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Understanding Leveraged Exchange Traded Funds, ETFs

When leveraged exchange traded funds, ETFs, burst onto the financial scene in 2006, investors viewed them as a golden ticket to double, even triple their investment returns. The potential for bigger returns, however, also came with more risk, complexity and higher administrative costs. Unfortunately, many investors were unaware of the hidden dangers of leveraged ETFs and the complex financial engineering they employ.

As their name implies, leveraged exchange traded funds have "leverage" openly embedded into their design. The products operate by using futures, options, equity swaps, and derivatives to multiply the daily returns on a given index. The operative word is daily. Investors who hold leveraged ETFs for longer than one trading day may get return results that are far different from what they initially envisioned or were promised by their financial advisers.

Exchange Traded Funds, ETFs blog

In recent years, regulators have become concerned about the suitability of leveraged ETFs for the average retail investor. Two years ago, the Financial Industry Regulatory Authority (FINRA) issued a reminder to brokers and advisers on selling leveraged ETFs. Among other things, FINRA cautioned about the instruments' complexity, stating they were generally inappropriate for individual investors planning to hold them for the long term.

In 2010, leveraged exchange traded funds found themselves on the North American Securities Administrators Association's list of the Top 10 Investor Traps of the year.

As Jim Cramer, a former hedge fund manager and now host of CNBC's Mad Money, stated in an MSN article earlier this year, leveraged funds do very little to level the investing playing field. Instead, they distort it.