Beware of Leveraged ETFs

Leveraged exchange-traded funds (ETFs) have gotten a lot of attention lately. Although the fund companies that produced them have thrived from their popularity, that party may soon be over. (Learn more about ETFs and why you might want to own some at www.fool.com/etf.)

Unfortunately, many investors don't fully understand how these things work. Leveraged ETFs are designed to deliver some multiple of the daily performance of whatever underlying index the ETF tracks. (A "2x" fund, for example, seeks to double the index's return.) But over time, daily movements in the underlying index can create losses for those who hold shares over longer periods of time — even if the index rises overall.

Here's just a small example, to show how scary they can be: the Direxion Daily Financial Bull 3x Shares ETF and the Direxion Daily Financial Bear 3x Shares ETF aim to triple the returns from the gains or losses in the financial sector. Think about it, though — that's already a rather volatile sector. Do you really want to risk tripling your exposure to it? Indeed, these securities have struggled mightily. The Bull 3x fund doubled in one month recently, but lost 41 percent over 12 months.

Regulators have questioned the sustainability of leveraged ETFs as long-term investments. The independent regulatory organization FINRA warned about the risks of inverse and leveraged ETFs this spring, stating that they are "unsuitable for retail investors (that's most of us) who plan to hold them for longer than one trading session, particularly in volatile markets."

In response, many big financial companies have either stopped selling leveraged ETFs or have placed restrictions on sales.

Yes, leveraged ETFs may be effective if you understand them and if you use them the way they're supposed to be used. But they're simply not structured for the average individual investor with a long-term horizon.

Whether leveraged ETFs will survive depends on whether there's a real market for risky short-term investments. If you want to make a long-term investment, though, you'll almost certainly do better just steering clear of them.