shrunkkidsBy now you’ve probably read in multiple places that Ultra ETFs are only a trader’s best friend, but shouldn’t be used for actual investing. Several articles in the financial news media, particularly on SeekingAlpha, already pointed out how in several instances both the Ultra Bull and Ultra Bear ETFs lost money for the investor.  If you haven’t heard of this phenomenon yet, then read this article and watch the video.

Now, it is also no secret that these products aren’t broken. They actually more or less do what they’re designed to. Their goal is to lever your daily, not your long term returns.

Let us look at a small example: An unlevered ETF starts out at 100 and then alternately loses and subsequently gains 5 % day after day. Over time this will result in you losing money in the underlying ETF: after 200 days you’d be left with $ 77.85.

Now let us look at how the two Ultra ETFs would have fared. The Ultra Bear, who is supposed to gain when the underlying ETF loses, would have actually lost way more and would end up at $ 36.60. How sad is that? You had the correct view and yet you lost your shirt. Interestingly, the Ultra Bull would also be around $ 36.60. So you’d have lost money on both funds, even though they did exactly what they were designed for.

So does this really mean that these two funds are only a trader’s best friend? Actually, no, they can still be used as a hedge for a regular long-term portfolio, provided that you do simple dynamic hedging. This means that at the end of the day you would have to take some profits if your Ultra ETF went up or buy additional units if it went down.

The mathematics of how much you’d have to buy or sell depend on your market outlook and your goal for the hedge and this is beyond the scope of this short post. I just wanted to point out something that I haven’t seen come up in any of the countless “Ultra ETFs are poison” posts all over the web.