Why Leveraged ETFs Are Considered Among the Market's Most Speculative Products

Exchange-traded funds (ETFs) are attractive investments for investors seeking instant diversification into a basket of stocks across a given sector, region, or index. For example, ETFs that track the entire S&P 500 -- like Vanguard's S&P 500 ETF (NYSEMKT: VOO) -- give investors exposure to all of the benchmark index's stocks through a single ticker. Another popular ETF, the Invesco QQQ Trust (NASDAQ: QQQ), tracks the higher-growth Nasdaq-100.

Those ETFs can be great options for investors who want to profit from the stock market's long-term growth but don't have the time to manage individual stocks. The stronger companies also naturally remain in those indexes, while the weaker ones drop out. As Warren Buffett famously said: "All there is to investing is picking good stocks at good times and staying with them as long as they remain good companies."

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However, Buffett also warned investors to be "fearful when others are greedy" -- and certain types of ETFs are targeting those greedy investors. Let's take a look at the riskiest type -- leveraged ETFs -- and see why they're dangerous investment products.

What are leveraged ETFs?

Most leveraged ETFs aim to double or triple the performance of an underlying stock or index. For example, Direxion's Daily S&P 500 Bull 3x Shares (NYSEMKT: SPXL) aims to triple the daily performance of the S&P 500.

To deliver that return, it trades derivatives, such as swaps and futures, daily. So if Direxion wants to invest $100 million in the S&P 500, it works with a bank that provides a "synthetic" $300 million investment via a short-term loan called a "total return swap". In this swap, the bank invests $300 million in the S&P 500 on behalf of Direxion, agrees to pay the fund triple the daily gain, but collects interest on the loan until the contract expires.

These total return swaps can last for weeks, months, or even years -- but their gains or losses aren't cumulative; they reset every day. In other words, this 3x ETF might triple the S&P 500's gain on one day, but it can also incur losses 3x as large the following day if the index pulls back.

In a prolonged, uninterrupted rally, it can outperform the S&P 500. However, a few days of choppy trading or declines will erase those gains, leading to compounded losses. Most leveraged ETFs also charge high fees to cover the interest payments on their swap contracts. The SPXL charges a net expense ratio of 0.87%, which is much higher than VOO's 0.08%.

Therefore, most of these ETFs are better suited for short-term day traders instead of long-term investors. A bullish leveraged ETF might seem like an excellent investment during a lengthy bull market, but it can quickly backfire once the market pulls back.

Why aren't leveraged ETFs reliable investments?

If you expect the S&P 500 to continue rising over the next decade, buying a leveraged ETF for the index might not seem too risky. Over the past 10 years, SPXL rallied 1,380% as the S&P 500 advanced 274%. Yet to achieve that gain, you would have needed to endure some steep daily downturns -- which were three times as steep as the index's -- without selling your shares.

However, other leveraged ETFs take on even more risk by targeting a single stock. One prominent example is Direxion's Nvidia Daily Bull 2x (NASDAQ: NVDU), which aims to double Nvidia's daily gains or losses with the same derivatives strategy. While Nvidia will likely keep growing as the AI market expands, trying to double its daily gains through a leveraged ETF is a greedy strategy that will inevitably backfire.

Leveraged ETFs might be appealing for specific short-term traders, but they're too speculative for most long-term investors. Doubling or tripling the daily gains of a single index or stock might sound wonderful in theory, but most investors can't stomach those volatile swings and losses.

Leo Sun has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Vanguard S&P 500 ETF. The Motley Fool has a disclosure policy.