Barron’s recently examined how the double-leveraged and double-inverse leveraged ETFs out of ProShares, Rydex and Direxion can create startling and distressing results for investors who correctly pick the direction of the market.
In the four months following the end of the Beijing Olympics, the Chinese stock market plunged 34%. Investors who bought the ProShares UltraShort FTSE/Xinhua China (FXP) right after Olympics and held on expected to see a return of 68%. Instead they received a 56% loss.
The devil is in the details. The leveraged funds only guarantee double the return on a daily basis. So, if the fund falls 20% one day and rises 20% the next, the investor isn’t even. That’s because the initial base on the second day is only 80% of the first day’s total. The Barron’s piece, One-Day Wonder, gives a good simple explanation. For more details on how this works, check out Chapter 9 of ETFs for the Long Run.