Ask a Fool: Is a Triple-Leveraged S&P 500 Index Fund a Smart Long-Term Investment?

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Q: Stocks are volatile over the short term, but their long-term returns can be quite consistent. Wouldn't buying a triple-leveraged S&P 500 ETF and holding it for say, 30 years, be the best long-term investment?

Here's the short answer: No -- pretty much the opposite, in fact.

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Leverage can be great when stocks go straight up, but can magnify losses to the point of financial ruin when the tides turn. Plus, leveraged ETFs tend to have high expense ratios, especially for funds that essentially just track a stock index.

It's important to discuss how leveraged ETFs actually work. Virtually all leveraged ETFs track a multiple of an index's daily return, not its long-term return. Over time, this produces an inherent downside bias.

For example, let's say that the S&P 500 loses 5% of its value for three consecutive days. In other words, after one day, it would be worth 95% of its starting value, then lose 5% of the new value, and so on. Over the three days, the S&P 500 would be worth about 86% of its original value, and would then need to rise by 16.3% in order to break even.

On the other hand, a triple-leveraged ETF would lose 15% per day for three straight days. At the end of three days, it would be worth roughly 61% of its original value due to the compound losses.

Here's the key point: In order to get back to even, this ETF would need to increase by 64% -- nearly four times as much as the S&P 500 would need to rise to erase its losses. Over time, this effect can snowball into big losses, even if the index does reasonably well.

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