Ultra ETFs: The Ultimate Addition To Your Portfolio?

Ultra ETFs can be an extremely valuable trading tool for a nimble investor, but a lot of risk is packaged with the returns. These ETFs can be very beneficial for investors who are short on capital, but they are also unpredictable due to the high amount of leverage and the way in which they can diverge from long-term expectations.

What Is an Ultra ETF?
An ultra ETF, sometimes referred to as a leveraged ETF, is simply an exchange-traded fund (ETF) that uses leverage. These ETFs often utilize derivatives, options or futures to offer an investor an instrument that produces double, triple or another multiple of the returns of the underlying index or benchmark on a daily basis.

ProShares offered one of the very first ultra ETFs in 2006, with the introduction of its Ultra ProShares. As an example, ProShares Ultra S&P 500 (ARCA:SSO) is an ETF that is designed to double the performance of the S&P 500 on a daily basis. So, if the S&P increases 1% on the day, SSO would typically be up around 2% on the day.

When they were initially introduced, the basic index ETFs provided investors with instant diversification and an incredibly convenient tool to get immediate market exposure, without having to create a portfolio of individual stocks. Since their launch, their popularity has grown tremendously. ETFs are also extremely liquid trading instruments with expense ratios ( annual operating expenses divided by average annual net assets) that are usually fairly low. Because of their success, many ultra ETFs were then launched to give investors and traders more tools and options to take advantage of market volatility.

Advantages
Leverage – Ultra ETFs allow an investor the potential to generate higher returns with the same amount of capital. This makes them an excellent tool, particularly for short-term traders. A trader with limited capital can now take a relatively small amount of capital and generate substantial percentage returns with an ultra ETF, especially in a volatile market environment, where 3 to 5% returns in a single day are commonplace. A 3% return in the market would equate to a 6% return for a holder of an ultra double ETF.

IRA Benefits - Ultra ETFs are somewhat beneficial for IRA accounts, as they can duplicate the leverage of margin trading where trading in margin is typically banned. Although these ETFs can reproduce the margin effects, it is generally not advisable to use volatile leveraged ETFs designed for day trading inside your retirement account.

Easy Short Exposure - The inverse are short ETFs, which allow an easy method to short the market without margin or the requirement to get short approval, which is often the case for stocks.

An Array of Options - There is now a broad selection of ultra ETFs that continues to grow. Ultra ETFs exist for the major indexes, S&P 500 sectors, oil, gold, bonds etc. Every major market (stocks, bonds, commodities, currencies) typically has a corresponding leveraged ETF. In addition, the more leveraged three times ultra ETFs give traders daily returns that are about three times the daily returns of the underlying benchmark.

Hedging – Ultra ETFs can allow a portfolio manager or investor to hedge their portfolio with a single instrument. For example, an investor that is holding a large portfolio of stocks short can simply buy an ultra long ETF if he or she feels that a rally may be approaching, and wants to offset the short exposure without covering his or her positions. They add a lot of flexibility and muscle to an investor's portfolio. Ultra ETFs may only be suitable for hedging for very short time horizons such as one day. However, non-leveraged ETFs are usually better suited if hedging for periods greater than one day.

Disadvantages
Leverage - It is a double-edged sword, as the volatility in some of these instruments can produce not only large gains, but tremendous losses in a short amount of time. For example, ProShares UltraShort Financials ETF (ARCA:SKF), the inverse ETF for the financial sector, hit a high of $303.82 on November 21, 2008, and wildly swung to about $100 just 10 trading days later. Trading these instruments requires constant attention and a strict trading discipline because the losses can be devastating.

Imperfect Tracking - Over longer periods, ultra ETF returns don't match the underlying index. They are only designed to track one-day performance, so holding a leveraged ETF for periods of greater than one day will almost guarantee results that will not mirror the underlying benchmark returns.

Timing Issues - Because timing is critical, leveraged ETFs are more suited for day trading rather than long-term investment.

Cost Issues - The ultra expense ratios tend to be much higher than regular ETFs, so they have a disadvantage on the cost side.

Conclusion

Ultra ETFs can prove to be very valuable if you're a flexible and diligent investor, and they can help create leverage in an account that otherwise could not. But, because of their volatility and correlation issues, they are best suited to short-term traders rather than investors.