ETF Talk: Learning to Love Leverage

If you want to maximize the return from making a wise investment in an exchange-traded fund, then you soon may love the leveraged funds that Direxion has rolled out.

Direxion launched eight ETFs during November 2008 that are leveraged to help both bullish and bearish investors triple the daily performance of the four indexes that they combine to track. The chance to earn a return that is three times the performance of an index could be especially enticing if you are confident about where the market is heading next. These ETFs not only are intended to triple an investor’s exposure to the market on the upside, but also on the downside.

These triple-leveraged investments are capable of extreme volatility, so they are not the place to put the college money for your kids and forget about it until they are mailing in their applications. As a result, you’ll want to be careful to limit how much of your hard-earned dollars you plan to invest. However, these types of funds may interest aggressive investors who don’t mind taking a risk with a small portion of their savings.

Leveraged long Direxion ETFs seek to triple the daily performance of an underlying index, such as the Russell 1000. In contrast, Direxion’s leveraged short ETFs try to triple the daily inverse performance of an underlying index. In short, if the index performs well, the long ETF is designed to magnify that performance. If the index does poorly, the long ETF is supposed to triple the losses.

Direxion has created two funds for investors to go either long or short in the Russell 1000. The first is Direxion Daily Large Cap Bull 3X Shares (BGU), which seeks daily investment results that are 300% of the price performance of the Russell 1000 Index. That particular index measures the performance of the large-cap segment of the U.S. equity universe. The fund has $267.8 million in assets and an average daily trading volume of 11 million shares.

The counterpart is the Direxion Daily Large Cap Bear 3X Shares (BGZ), which seeks to replicate, net of expenses, 300% of the inverse daily performance of the Russell 1000 Index. The fund, with $370 million in assets and average daily trading volume of 12.8 million shares, invests at least 80% of assets in securities that comprise the index.

The volume and liquidity offered by the funds add to their appeal. By the end of November 2008 — only one month after trading began — the eight funds had accumulated a total of more than $510 million assets. That is fast growth.

Leveraged funds, when used in hedging, may lower your risk portfolio. Of course, you must be able to accept the risks that come with leveraged funds. One potential risk arises from the tracking error between the funds and their underlying index. Especially during times of high volatility in the market, an investor cannot expect the funds to triple the performance of the index, either going long or short. It is yet another reason to use such funds as short-term trading tools rather than to buy and hold.

These funds can be deployed in three key ways:

• You can place small, short-term bets when the markets are volatile.
• When the market takes off and you find yourself left behind, these ETFs can help you to catch up.
• You also can use the funds as hedging tools.

Remember that knowing how and when to use funds is the key to investing profitably. If you want my advice about which ETFs to trade and when, check out my ETF Trader service by clicking here . As always, I am happy to answer your questions about ETFs. To send me your questions, click here. I will try to follow up in a future ETF Talk.