Are Leveraged ETFs Too Risky for Most Investors?

As consumers, we tend to think more is better than less ... especially when that "more" is free.

As investors, though, you should be cautious of adopting the same mindset and embracing so-called leveraged investments that magnify the market's moves. These instruments often end up doing you more harm than good, if only because they can easily prompt you into making misguided decisions.

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What are leveraged ETFs?

If you're not familiar with them, they're not complicated. Exchange-traded funds like the ProShares Ultra 2X S&P 500 Fund (NYSEMKT: SSO) move in sync with the S&P 500 (SNPINDEX: ^GSPC), but move by twice as much; the Direxion Daily S&P 500 Bull 3x Shares (NYSEMKT: SPXL) move three times as much as the underlying index.

It's not just bullish funds based on broad market indexes, though. The Direxion Daily Semiconductor Bull 3x Shares (NYSEMKT: SOXL) magnifies the net movement of semiconductor stocks by a factor of three, while the ProShares UltraPro -3X Short QQQ (NASDAQ: SQQQ) moves three times as much in the opposite direction as the Invesco QQQ Trust (NASDAQ: QQQ) does. Yes, you can make gains with this particular ETF while the QQQs are losing ground.

Sounds great, right?

There's a reason, however, these seemingly no-brainer investment vehicles haven't caught on in a big way even though they've been around for a long, long time. Several reasons, actually.

One of them is the simple fact that they don't consistently work nearly as well as intended. Their managers utilize futures and/or options to produce leveraged results. These are instruments that inherently lose value over time, and they significantly fall short of expectations when the market stagnates. They're also relatively expensive to constantly trade. For perspective, the ProShares Ultra 2X S&P 500 Fund's annual expense ratio is nearly 0.9%, which is a fortune in a world where ordinary buy-and-hold index funds often incur an annual management fee of less than one-tenth of 1%. These fees ultimately come out of investors' bottom lines.

Perhaps the chief reason leveraged ETFs aren't right for most ordinary investors, however, is that they have a funny way of keeping you constantly tuned into your portfolio's every move and ready to make an exit the first time there is even a hint of trouble. As veteran investors can attest, though, it's patience that pays off even when it's uncomfortable to stick with something.

Just go with what's proven to work

This isn't to suggest there's never going to be a time to utilize leveraged exchange-traded funds. There may be rare scenarios where the limited use of these tools makes sense.

But for the vast majority of investors, the vast majority of the time, leveraged ETFs bring too much risk to the table to justify the reward you could realistically squeeze out of them. The whole point of buying and holding quality stocks is specifically because you can't predict near-term ebbs and flows. You just want to be in them whenever they dish out their long-term gains. With levered ETFs, you're essentially betting you can navigate the market's short-term ebbs and flows with any degree of consistency. You can't. If it were possible, someone would have demonstrated it can be done by now.

Bottom line? Don't try to be clever or cute. Just stick with the buy-and-hold approach that's proved to work for decades.

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.