These ETFs can trash your portfolio

By Donald Luskin, SmartMoney

Leveraged exchange-traded funds, or LETFs, have become quite the popular investments.

The 146 leveraged and inverse funds got almost $19 billion in net inflows for the 12 months ending in October, according to fund researcher Morningstar.

LETFs are designed to give you twice the return of some market index, sort of like trading stocks on a 50% margin. You get twice the bang for your buck and twice the risk. They are similar to inverse funds, which allow an investor to bet against an index. Some are leveraged and short.

But there's a hidden danger in leveraged exchange-traded funds that even the sophisticated active traders who use them often don't understand: The promise of a leveraged return is accurately delivered by LETFs only over any single trading day.

Held over multiple days, the returns are completely unpredictable and can deal you some nasty surprises. That can work for you or against you.

Multiplying your results

For example, suppose you bought the ProShares Ultra S&P500 (SSO, news, msgs) fund at the bottom in March and held it through the end of November. The underlying S&P 500 Index ($INX) gained about 64% over that period, so you'd expect the Ultra fund to return twice that, or about 128%.

But wait: In fact, it returned about 153%.

That was lucky. It's not always that way. Suppose you bought the same fund the very first day it traded, which was June 20, 2006, and held it through the end of November 2009. The S&P 500 is down about 5%, so you'd expect the Ultra fund to be down about 10%.

But no. It's down 42.5%. Only about 3% of that can be explained by the long-term performance drag of fund fees.

I don't mean to pick on the ProShares Ultra S&P500 fund. All the leveraged ETFs, no matter which company sponsors them or which index they track, suffer from exactly the same performance unpredictability.

Don't say you weren't warned

To be fair, this problem is fully disclosed in all the LETFs' prospectuses. But, hey, real men don't read prospectuses. Maybe in this case they should.

If what I'm telling you seems impossible, follow me through a very simple example, and you'll see just how it works. Don't be embarrassed. When I first heard about this, I didn't believe it.

Let's say you pay $100 for an LETF that tracks an index and that the index is at 100. If the index goes up 20% the first day, it will be at 120. Your LETF promises you twice the 20% return -- that's 40% -- so your $100 grows to $140. So far, very good. Now suppose the next day the index falls back to 100. That's a drop of 16.7% (after rounding), so the LETF has to give you twice that -- a loss of 33.3%. Does that bring your LETF back to $100 where you bought it?

You might think it would. Since the index is back to square one, why shouldn't your LETF be back there, too?

Simple. Your LETF was worth $140, and 33.3% of that is $46.62. So your LETF is now worth $93.38, not $100. You see what happened? Over each of the two single days, the LETF did exactly what was promised -- exactly twice the daily return of the index.

But over both days put together, it didn't do that at all. Over two days, the index had a zero return. So you'd think the LETF should give you twice zero, which is still zero. But, no, it gives you a net loss of 6.6%.

Suppose the same thing happens for 10 days -- the index goes up 20, then down 20, and so on over and over. By the end of the 10 days, your LETF has a net loss of 29% even though the index is unchanged. After a month of this, the LETF has lost 64%.

The index is still dead even, but the LETF is just dead.

The black magic of compounding

It's a strange case of the so-called magic of compounding. But this time, it's the dark arts, and, unlike with Harry Potter, there is no defense. It seems there is no way to re-engineer leveraged ETFs so they don't act this way.

Fortunately, it's not usually a problem over short periods. Obviously, it's no problem at all intraday or over any single day, so superactive traders can pretty much ignore this problem.

But many traders who are quite active nevertheless hold positions for days or weeks. Then this problem can really bite you, because it is most intense when the market is most volatile -- that is, when it has a lot of reversals of large magnitude. The effect is negligible in a trending market where most of the moves are in the same direction day after day.

And it cuts both ways. It can work for you as much as it can work against you. The problem is you never know in advance. And that's disappointing, because we like to think that sophisticated instruments such as leveraged ETFs are examples of the perfection of financial engineering.

The reality is that they just aren't perfect.