Beware of amped-up ETFs

By Janice Revell,

FORTUNE -- Given the extreme volatility in the market these days, the idea of being able to capitalize on all that whipsaw action is alluring. And the fund industry is offering that very opportunity, in the form of leveraged exchange-traded funds.

They're a day trader's dream, and they've been increasing in popularity. But beware: Used improperly, these high-octane investments can wreak destruction on your portfolio -- even if the market moves the way you anticipated.

Leveraged ETFs are amped-up versions of traditional exchange-traded funds, which track the performance of various indexes and asset classes including stocks, bonds, commodities, and currencies. These funds -- which go by such names as "Ultra" or "Double Long" -- use derivatives to deliver two or three times the daily returns of the underlying index. Inverse leveraged ETFs (a.k.a. "Double Short" funds) are designed to produce the opposite performance of the benchmark they track and give investors a way to profit from a declining market.

Sales of leveraged ETFs have soared recently, and now account for about $45 billion in investor assets. As the market tumbled in August, investors plowed about $3 billion into leveraged ETFs, the second-highest money inflow of all ETF categories, according to research firm Strategic Insight.
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But here's the problem: If you hold a leveraged ETF for more than 24 hours, your returns could be drastically different than what you might expect. That disconnect has prompted both the Securities and Exchange Commission and the Financial Industry Regulatory Authority to issue investor alerts.

The danger lies in the fact that most leveraged ETFs "reset" daily. That resetting, combined with leverage, can cause an ETF's returns over weeks or months to diverge wildly from that of the benchmark. "Predicting the direction of the market is only part of the challenge," says Paul Justice, director of ETF research at Morningstar. "You also have to correctly predict the path the investment is going to take."

Here's how resetting can distort returns. Say you make a $100 investment in both a traditional index fund and a "Double Long" fund that tracks the same underlying equity index. On day one the index rises 10%. The regular index fund closes at $110 and the leveraged ETF adds 20% to finish at $120. Then on day two the index falls 10%. The traditional fund drops to $99 (a 10% loss from $110). But the leveraged ETF plummets to $96, because it started the day at $120 and its return was -20%, or a $24 loss. Repeat that process 50 or 100 times, and the gap between expected and actual returns can grow wide.

If you want to roll the dice on what the market will do tomorrow -- with money you can afford to lose -- then a leveraged ETF is a useful tool. But to make a real investment, stick with plain-vanilla funds.

-- A former compensation consultant, Janice Revell has been writing about personal finance since 2000.

This article is from the December 26, 2011 issue of Fortune.