Leveraged ETFs Are Designed to Be Aggressive and Speculative. That's Both the Appeal and the Risk.

Some people may look at leveraged ETFs and think that they're the perfect way to amplify long-term returns. After all, if you see the S&P 500 rising on average by 10% per year, why not put your money in the Direxion Daily S&P 500 Bull 3x Shares ETF (NYSEMKT: SPXL) and turn it into 30% per year?

Since that's not how they work, and if you buy and hold these leveraged ETFs with that intention, the odds are good that you could do serious unintended damage to your portfolio.

Leveraged ETFs are designed to magnify a single day's return, nothing more. As I'll demonstrate in a moment, if you hold them for any longer than that, you can experience a wide range of returns. In many cases, that won't be a good thing.

Image source: Getty Images.

How leveraged ETFs work

When you invest in a leveraged stock ETF, such as the Direxion Daily Semiconductor Bull 3x Shares ETF, you're not actually investing in stocks at all.

You're investing in derivative contracts, such as swaps or futures, that are designed to deliver a multiple of exposure to the underlying security or index. For example, in the case of this ETF, its goal is to deliver 300% of the daily return of the NYSE Semiconductor Index.

Notice I said "daily return." At the end of each trading day, the leverage is reset and the process repeats. It's important to emphasize that leveraged ETFs are only designed for single-day holding periods. Considering the high degree of volatility that also comes from using leverage, they're only appropriate for aggressive traders and speculators.

That can be read as a warning to most. But for some, that's part of the appeal. If you have high conviction that Nvidia, for example, will beat its quarterly earnings expectations and you think the stock will soar, you might want to make a single day trade in the Direxion Daily NVDA Bull 2x Shares ETF. If you're right, you could double that day's performance gains.

Of course, the reverse will be true if you're wrong. That's why leveraged ETFs are only appropriate for those with a real stomach for risk.

Volatility can be incredibly damaging to leveraged ETFs

While leveraged ETFs can be useful for single-day traders, the two biggest dangers to them are time and volatility.

Leveraged ETFs usually come with the highest expense ratios, sometimes 1% or more annually. Plus, there's the cost to the fund that comes with setting and resetting leverage every business day. Those costs create a drag on performance. And that drag grows the longer you hold one of these products.

Volatility decay may be the biggest enemy of all. Let's take a look at a hypothetical example of how high volatility can damage returns over longer holding periods.

Data source: Author example

In the "Daily Return" column, we see that the underlying security has experienced significant swings over the past five trading days. The "3x Daily Return" and "-3x Daily Return" columns demonstrate how the leveraged ETF should closely approximate the expected returns for that day.

The cumulative returns columns, however, show how returns can be impacted over time.

If you held this stock outright, you would have experienced a 2.2% gain over the five-day holding period. The 3x leveraged ETF actually ended up returning just 1.2% over the same time frame even though it had triple the daily leverage and the underlying stock delivered positive returns. The -3x leveraged ETF ended up losing 16%, far more than one might have expected.

This is the danger of holding leveraged ETFs for longer time frames. For a single day, they can be very useful. Any longer than that and your range of potential returns could be very wide.

Leveraged ETFs are risky, but they can be useful

At a basic level, leveraged ETFs are appropriate only for those planning on holding for a single trading day and willing to stomach some significant short-term risk. They can be useful for traders making a high-conviction bet on a single event, such as earnings or an economic report.

For most, however, simply buying and holding stocks, bonds, and ETFs is the best way to go.

David Dierking has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Nvidia. The Motley Fool has a disclosure policy.