Falling Behind: The Price Of Not Using Leverage

If you're not using a leveraged or inverse fund these days, your chances of owning a top-performing ETF is greatly reduced.

On the other hand, if you do own a leveraged or inverse ETF, that doesn't guarantee a winning hand. In fact, it might ensure just the opposite.

With leverage, if your ETFs haven't made any of the "best" lists lately, chances are you're going to wind up a big-time loser.

In the world of highly charged ETFs that provide 200% or even 300% leverage of their underlying indexes, few performance numbers fall in between the cracks. It's an all-or-nothing game.

For example, if you'd bought the Rydex Inverse 2x S&P 500 ETF (NYSE: RSW) one year ago today, you would've gained more than 40% by now. If you'd bought the ProShares Ultra S&P 500 ETF (NYSE: SSO) in that same period, you would've lost 60%-plus.

The only real pattern showing up since the onslaught of leveraged and inverse ETFs on the market is that leaders will more likely than not come from one of those two categories. Whether it's one or the other is dependent, of course, on the particular cycle at the time.

So how can you hope to own a real ETF winner without juicing up your portfolio these days?

It's easier than you think. And best of all, you really don't need 2x or 3x ability to be a top performer. In fact, it's probably counterproductive for most long-term investors to own a leveraged ETF.

A few years ago, when international equities were outperforming and the U.S. dollar was getting pummeled, investors were warned about the rise of single-country ETFs.

The concern was that these niche ETFs would wind up dominating more-diversified funds and splinter such a fast-growing market into near oblivion for long-term investors.

Now, a new leader has emerged, in leverage. And that has brought up the same concerns.

Last year, inverse ETFs aiming to provide 200% and 300% performance cleaned up. Consider that all but one of the top 20 ETFs in the past 12 months are built to short their indexes. The lone exception is the Vanguard Extended Duration Treasury Index ETF (NYSE: EDV).

More to the point, 15 of those 19 were using 2x or 3x inverse coverage to heighten returns in a strongly downward market. The remaining four single inverse (-100%) funds didn't have any amped-up competition.

In the past month, as markets have strongly rebounded, leveraged ETFs have moved into the forefront. The Direxion Daily Financial Bull 3x Shares (NYSE: FAS) is the leader with a better than 60% return during that time frame. In fact, the only two nonleveraged ETFs to make it into the top 10 have been the Market Vectors Indonesia ETF (NYSE: IDX) and the Rydex S&P SmallCap 600 Pure Value ETF (NYSE: RZV).

The problem with using souped-up inverse and leverage is that if you're right, you can become a hero. But if you're wrong, you can become a real goat.

And that doesn't just apply to deciding between short and going extra long with your funds. You can get whipsawed within the same fund very quickly, no matter whether it's of the inverse or leveraged type.

Take for example what would've happened if you were to have bet on the Ultra Russell MidCap Value ProShares (NYSE: UVU). In the latest rally—now entering its sixth week—you would've made more than 30%. But if you held it during the course of the past year, you'd be down close to 70%.

By comparison, if you had bought the nonleveraged iShares Russell Midcap Value Index (NYSE: IWS), your gains in the past month would've only been around 20%. But your losses in the 12 months could've been pared nearly in half.

Longer-term examples aren't available for ETFs. But plenty of mutual funds do much the same in terms of attempting to short or leverage indexes. Most any way you slice and dice it, analyzing those tendencies show similar trends.

Take the ProFunds UltraShort NASDAQ-100 Fund (USPIX). In the past 10 years, according to Morningstar data, it had a total return of -19.62% through last week. In that same decade, the PowerShares QQQ (Nasdaq: QQQQ) was down about 5%.

As long as markets keep moving up over time, bypassing leverage and inverse ETFs in favor of traditional long-only index funds makes sense. The argument against taking a buy-and-hold approach and relying on asset allocation for most of your gains does hold water if stocks don't increase in value by the time you need the money.

Then again, if markets don't make any gains over longer periods of time, the prospect of investing in stock markets probably won't be very attractive to a lot of people. The lone exception might be traders and sophisticated index-based institutional technicians.

As new ETFs come out offering different approaches, it's going to become more important than ever for long-term-minded investors to stay the course. That means putting today's returns into some sort of long-range perspective.

That's going to become harder and harder to do, as all the razzle-dazzle goes to the new funds.

As the new ETFs have been rolling out the industry's proverbial assembly line, we've been taking extra pains to point out each one's strengths and weaknesses. Inverse and leverage providers themselves are emphasizing that their products designed for traders—not investors—especially those with longer horizons.

The complaint that these newfangled funds are nothing more than the latest craze—just like single-country ETFs—might be right. But it's not fair to label them as a bad idea. More options are better for everyone, although that might not be true in your specific case. Instead of trying to ban leverage, as entertainers and riddlers like Jim Cramer suggest, you can use them to define your perspective even more.

Last week, I got really sick. It turned out to be a drink from our local grocery store. Under the fine print on the bottle, I found the reason why—it had a very small reference to an ingredient that doesn't sit well with my system.

So should I have blamed the distributor? Well, I tried. But my wife pointed out that not reading the labels of something before buying it—when I know what can hurt me - is my own fault.