By Brendan Conway

Its the latest idea for your grandmothers retirement money: Investing in a triple-leveraged exchange-traded fund.

Wait a minute.  What?

In the research Ive done, [triple-leveraged ETFs] played a pretty vital role in providing a large amount of upside, but they need to be paired with a conservative anchor in a portfolio, says Jason Scott. director of the Retiree Research Center at Financial Engines Inc., a Sunnyvale, Calif. company that provides advice and money management to 401(k) participants. 

The [strategy] puts forward a floor-leverage rule that calls for retirees to put 85% of their portfolio in low-risk, income-producing products such as annuities. Treasury inflation-protected securities or other government bonds. That provides a floor—a reliable stream of income. The remaining 15% can be invested in triple-leveraged stock ETFs. Each year, if the leveraged investments have grown to more than 15% of the portfolio, the strategy calls for money to be shifted to the income portion to maintain the target ratio.

Have retirees really grown so hungry as to want the trading vehicles for which Citigroup  (C ) and Morgan Stanley  (MS ) got multimillion dollar fines? Those firms sold leveraged ETFs to buy-and-hold investors ahead of the financial crisis. It didnt work out so well.

The key question for a retiree retiree meaning you have no job, and, thus, no way to replace money you lose in the market is what happens when a leveraged ETF plummets 25% or 50% in value. Which many do. And in unpredictable manners. And in markets that are much more benign than the financial crisis.

These are the most volatile, short-term trading tools in ETFs. The risk that one might plunge by 50% as the rest of the market zigs or zags is very real. The one cited in the WSJ article, Direxion Daily S&P 500 Bull 3X Shares  (SPXL ), fell 15% during 2011, a year when the S&P 500 gained 2%.

Another popular leveraged ETF, Direxion Daily Financial Bull 3X Shares (FAS ), fell 53% in the same year. In 2009, when risk assets roared higher, this one dropped 41%. Note that none of these performance figures occurred in a financial crisis-like calamity.

How did ostensibly bullish leveraged ETFs get shredded in 2011? The answer is the way that their portfolio holdings swaps, futures and so forth, which are rebalanced every single day react to a lack of direction in the stock market.

Its complicated enough that you can be correct about the direction of the market over a period of three or six months, or a year its hard enough just to predict that but still be wrong about the direction of a leveraged ETF.

Heres what the maker of the ETF cited in the story, Direxion Daily S&P 500 Bull 3X Shares,  says on its Website about its own fund:

This leveraged ETF seeks a return that is 300% the return of its benchmark index for a single day . The fund should not be expected to provide three times the return of the benchmark’s cumulative return for periods greater than a day.

You know that TRADING is different than investing. But the opportunity to take advantage of short-term trends is only won, if you get the direction right.

Whether you’re a bull or a bear, Direxion Shares is with you. Our leveraged ETFs are powerful tools built to help you:

• Magnify your short-term perspective with daily 3x leverage
• Go where there’s opportunity, with bull and bear funds for both sides of the trade; and
• Stay agile – with liquidity to trade through rapidly changing markets

Leveraged ETFs are not suitable for all investors and should be utilized only by sophisticated investors who understand leverage risk, consequences of seeking daily leveraged investment results and intend to actively monitor and manage their investments. Leverage ETFs are not designed to track the underlying index over periods longer than one trading day.

Note Direxions heavy emphasis on short term trading. Heres what this blog said on the subject in January, specifically that investors can be right about the direction of the market but wrong on the leveraged ETF returns w hen your spidey sense about market volatility is wrong. From Wells Fargo Advisors analysts this blog quoted back then.

[L]ow volatility relative to the return of a geared ETP’s underlying index is crucial for satisfactory returns among geared ETPs. Too many users incorrectly assume that accurately guessing the direction of a geared ETP’s underlying index is sufficient. It is not! Correctly guessing low enough volatility is necessary as well.

It may be that what risk-averse retirees are really after is enhanced performance from a smaller exposure to risky assets. I, too, would like to have my cake and eat it, too.

Of course, the argument in favor of leveraged ETFs looks attractive after the strong returns have been achieved. But theres an unusually low level of certainty in the here-and-how that youre actually going to achieve them.

In case its not yet clear, no, your grandmother shouldnt be invested in triple-leveraged exchange-traded funds.

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