By Scott Ronalds

Gold was up roughly 1.5% in 2008 (as measured by the S&P/TSX Global Gold Index) – a good year relative to most other investments.  If you used a slick new breed of leveraged exchange traded funds (ETFs), you could have doubled your exposure to the commodity through the Horizons BetaPro S&P/TSX Global Gold Bull Plus ETF, and expected a return of 3%.  Or so the thinking goes.

Problem is, you would have lost money – and a lot of it – if you chose to double-up your exposure to the commodity through the BetaPro ETF.  The fund in question dropped 45% in 2008 (the Bear Plus version was down 84%).  Yet, it did what it was supposed to do.  That is, seek daily investment results equal to 200% of the daily performance of the S&P/TSX Global Gold Index, before fees and expenses.  The key word here is daily.  If the fund’s goal was to provide 200% of the annual return of the index, you would have got what you expected.

Because stock and commodity prices can swing so much from day-to-day, these leveraged ETFs can produce returns that are wildly different from what investors might expect, as was the case with the Gold Bull Plus ETF last year.  With these products, a few large downturns in the price of the underlying investment can wipe out any past gains in a hurry while at the same time reducing the positive impact of any future price gains.  The more volatile the daily price movement, the more the return of the ETF may diverge from the investment it tracks.

Leveraged ETFs are not for the average investor.  As a detailed article published by Morningstar (USA) points out, they are best used by short-term speculators, and by large institutional investors who need to manager their liquidity.  The author issues the following warning:

“They are not meant to be held as long-term investments, and very bad things not only can happen whenever you hold these ETFs longer than their indicated compounding period, you are almost mathematically guaranteed to get a return that is not double that of the index.  In fact, the longer you hold one of these funds, the probability that you will get nothing close to double the returns increases.”

Judging by the increasing number of these products on the market, there is clearly a demand for them, and they can be useful tools for some investors.  But they’re misunderstood by many and unless you’re the gambling type or need a short-term (i.e., one or two day) market exposure tool, they’re probably not for you. 

If you like the low cost and simplicity of ETFs, you’re best to stick with the original versions that track a broad market index and charge a fee of around a quarter of a percent (the management fee of the Gold Bull Plus ETF is 1.15%).  As more features are added to these products, fees creep up and the more they move away from their original purpose – low cost market exposure.  Buyer beware.