The goal of Leveraged and short ETFs (those that move inverse to the underlying) is to magnify their gains and to provide inverse market performance to various stock, bond and commodity indexes on a daily basis. Because they aim to achieve investment results that usually target the daily returns of their underlying benchmarks, they are usually best suited for investors with a short-term investment time horizon. Since leveraged and short ETFs are primarily designed to achieve daily returns, their long-term performance is highly likely to be much different from the long-term performance of their respective underlying indexes.

With all of the very attractive inverse and leveraged products available, a common question I get is why should I avoid them, and why should I use them? Today we analyze an example of how the performance for leveraged and short ETFs works so you may be better able to decide for yourself.

Let's assume you invest $1,000 in two different ETFs (table below), a triple leveraged ETF and a triple inverse performing ETF. Suppose the underlying index increases by 5% on a single day. After the market close, the triple leveraged ETF gained 15% while the triple inverse ETF lost 15%. Both types of ETFs performed as designed. Everything looks good at this point.

Beginning ValuePerformance return on day 1Value at the end of Day 1Total performance return. 

Index Value100+5%105+5%

3x Leveraged ETF$1000+15%$1150+15%

3x Short ETF$1000-15%$850-15%

Now let's suppose the index declines in value by 5% the following day (table below). Over the entire two-day period the index has lost 0.25%. However, the performance for both leveraged ETFs over the same two-day period produce much greater losses of negative 17.25% and negative 2.25%. This example illustrates how the returns of leveraged ETFs are much more exaggerated and dramatic than their underlying indexes. Also, over longer periods of time the performance of the funds is likely to deviate from their underlying benchmarks due to the compounding effect of fund fees, index volatility and tracking error.

Beginning ValuePerformance return on day 1Value at the end of Day 1Total performance return. 

Index Value105-5%99.75-0.25%

3x Leveraged ETF$1150-15%$977.50-17.25%

3x Short ETF$850+15%$977.50-2.25%

Let's assume the same pattern of returns (positive 5% one day followed by negative 5% the following day) for 30 consecutive days. At the end of 30 days, the index lost 3.69%. If you work out the math you find that interestingly enough, while both the leveraged long and leveraged short ETFs have opposite daily goals, they both finish the 30 day period with the same 28.92% loss.

So if you are considering using leveraged ETF's in your portfolio you might want to be sure that you have a very short investment time horizon of just a few days. That's because the investment objective of virtually all leveraged and short ETFs is to achieve short-term investment results that correspond to the daily inverse or daily magnified performance of their respective indexes.