Do Leveraged ETFs Belong in a Long-Term Investment Portfolio?

The premise sounds awesome. Whatever gains the market is making, you're gaining twice as much, or even more! That's what instruments like the Direxion Daily S&P 500 Bull 2x Shares (NYSEMKT: SPUU) or the Direxion Daily S&P 500 Bull 3x Shares (NYSEMKT: SPXL) do, magnifying the S&P 500's daily movement by a factor of two, if not three (respectively).

There's a flipside to this upside, however. Just as leveraged exchange-traded funds (ETFs) dramatically increase marketwide gains, they just as dramatically increase marketwide losses. Even for patient investors comfortable riding out bearish storms, these sorts of magnified losses can really get in your head, prompting you to make ill-advised, ill-timed decisions.

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Yes, such ETFs exist

If you're not familiar with them, you're reading this right. There are several exchange-traded funds like the aforementioned Direxion ETFs or the ProShares UltraPro QQQ ETF (NASDAQ: TQQQ) using options and futures to leverage the net daily movement of their underlying index, or on the case of TQQQ, three times the net daily movement of the Invesco QQQ Trust (NASDAQ: QQQ).

There are leveraged bearish funds too, like the ProShares UltraShort S&P 500 ETF (NYSEMKT: SDS), which is designed to move twice as much in the other direction each day as the underlying S&P 500 index does. If you can buy this fund at the beginning of a pullback and get out of it at the bottom, you'll actually make money on marketwide sell-off.

There's just one gaping problem with any leveraged exchange-traded fund, though. That is, they rarely seem to provide enough reward to justify their risk.

Not perfect

Don't misunderstand. There's a decent theoretical case to be made for owning 2x and 3x index funds like Direxion's SPUU and SPXL. For instance, if you're truly committed to holding onto a broad-based ETF like the SPDR S&P 500 ETF Trust (NYSEMKT: SPY) "forever" because you're convinced that -- given enough time -- the market will perpetually move higher, you'll likely fare far better with such a tool.

They're not perfect, though. Although intended to move twice as much or even three times as much as their underlying index on a daily basis, because they utilize futures or options to achieve their goal of leveraged returns, these ETFs often underperform, particularly over longer periods with both upward and downward moves. That makes their net long-term risk disproportionally greater than their long-term potential upside.

They're also relatively expensive. Whereas SPY's annual expense ratio is just a little less than 0.1% of the fund's value, for perspective, the Direxion Daily S&P 500 Bull 3x Shares expense ratio of nearly 1% really chips away at your net performance.

Know what you can and can't handle

Perhaps their biggest risk, however, is the psychological one.

In contrast with the typical buy-and-hold mindset that allows investors to confidently stick with their stocks during periods of poor performance, leveraged ETFs invite and even encourage constant tinkering. It's too easy to justify what ends up being a bad decision, particularly in terms of exiting a trade.

And before you think you'll be an exception, know that every other investor who's lost money on leveraged exchange-traded funds thought the exact same thing.

Bottom line? Simpler is always better in the long run. So, don't let greed make things more complicated than they need to be. An investor is best served by just viewing themselves as a long-term owner of businesses that just so happens to be publicly traded. Introducing leveraged ETFs into the equation forces someone to think like a short-term speculator, which is far more difficult to do well.

James Brumley has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.