Exchange-traded funds (ETFs) are compelling investments well worth considering for your portfolio. They're very much like mutual funds, often encompassing a big bunch of securities and charging an expense ratio (fee), yet they trade like stocks, allowing you to buy or sell any time the market is open, from your brokerage account.
But all ETFs aren't equal, of course. Some, such as index fund ETFs with low fees, should serve you very well over long periods. But others can be dangerous -- and hazardous to your wealth. One kind of ETF you may want to steer clear of is the leveraged ETF, and a good example is the ProShares UltraPro QQQ ETF(NASDAQ: TQQQ). Personally, I wouldn't touch it with a 10-foot pole.
What's a leveraged ETF?
In the financial world, the word "leverage" typically refers to debt, and investors who can stomach a lot of risk sometimes invest with borrowed money. An individual investor might invest "on margin," for example, using money borrowed from their brokerage. A leveraged ETF, meanwhile, is one that employs debt and/or derivatives in order to deliver amplified gains to investors. Unfortunately, it can also deliver amplified losses.
Let's review a simple example of someone investing on margin: Imagine you have $1,000 to invest in stocks. You might borrow $1,000 from your brokerage, too, in order to have $2,000 with which to invest. If your investment doubles in value, your stake is now worth $4,000. Great! And you got that starting with only $1,000, so you've quadrupled your money!
But if your investment falls by, say, 70%, your $2,000 stake will fall in value to $600. That's bad enough, but remember that you borrowed $1,000. It wasn't a gift. You actually have to make interest payments on borrowed sums -- and eventually, you need to pay back the money. So you're out whatever interest payments you've made, and you have to pay back $1,000. So now you've actually lost $400.
If you'd suffered a 70% loss investing only your original $1,000, you'd have $300 left. But since you borrowed that extra $1,000, you now have negative $400. See? Leverage can greatly amplify your gains and your losses.
That's part of the problem with leveraged ETFs. They're riskier than simple ETFs that just invest in various securities in a straightforward manner.
Why avoid the ProShares UltraPro QQQ ETF?
Now let's look at one particular leveraged ETF, the ProShares UltraPro QQQ ETF. On its own website, it's described like this: "ProShares UltraPro QQQ seeks daily investment results, before fees and expenses, that correspond to three times (3x) the daily performance of the Nasdaq-100 Index."
The Nasdaq-100 is an index of the 100 largest companies trading on the Nasdaq Stock Market -- excluding financial companies. So it includes companies such as Apple, Microsoft, Amazon, Nvidia, and dozens of other major businesses you've surely heard of and probably admire.
So the ProShares UltraPro QQQ ETF aims to give you 3 times the return of the Nasdaq-100. That certainly sounds terrific -- but there's a catch or two. For starters, remember that amplification of losses. Whenever the Nasdaq-100 falls, the ProShares UltraPro QQQ ETF will fall harder. Much harder.
And then there's this: These kinds of ETFs are not designed to be long-term holdings that make you richer over years. They're actually designed to serve you over a single day. Lots of investors may not realize that, though, and if they take their eyes off the ball, they can end up in big trouble. That's because, due to the way these ETFs are structured, their returns over longer periods can deviate sharply from the benchmark they're based on. So if you hold this ETF for, say, a month, and the Nasdaq-100 goes up 5%, you may actually end up losing money. (This danger applies to all leveraged ETFs, not just this one.)
The U.S. Securities and Exchange Commission (SEC) has warned investors about leveraged ETFs (and inverse ETFs, another complicated kind of ETF), offering two examples:
Over four months, a particular index gained 2%. However, a leveraged ETF seeking to deliver twice that index's daily return fell by 6% -- and an inverse ETF seeking to deliver twice the inverse of the index's daily return fell by 25%.
During that same period, an ETF seeking to deliver 3 times the daily return of a different index fell 53%, while the underlying index actually gained around 8%. An ETF seeking to deliver 3 times the inverse of the index's daily return declined by 90% over the same period.
Fortunately, while I'm personally ruling out all leveraged ETFs (and inverse ETFs, for that matter), there remain lots and lots of terrific ETFs to choose from -- such as the Vanguard S&P 500 ETF (VOO), which will give you roughly the same returns as the S&P 500. That's likely to deliver solid gains over many years.
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