A master chef with the right kitchen toolsincluding a fine set of cutlerycan create a memorable dining experience.

But the same knife that produces a photo-worthy gourmet masterpiece can produce a messy result in the hands of a novice or distracted cook.

The same can be said for some investment instruments. Even if youve achieved a level of mastery or, at least, comfort with stocks, you might shy away from other assets because you know the end result can turn out a lot different than the recipe suggests!

When it comes to certain classes of Exchange-Traded Products, you can give them to an educated and experienced professional, and they can easily enhance their financial returns while minimizing risks.

But for those who dont take the steps to get comfortable with how to operate these powerful tools before they use them, the end result is usually an investment disaster.

Today lets look at a special class of ETFs that, with just a small bit of knowledge, can help turn you into an iron chef of the investing variety!

Ron Paul: Gold Could Go to Infinity!

Gold got crushed this week. The yellow metal is now down 30% from its highs trading at its lowest level in more than 2 years.

But as long as we have excessive spending and excessive computerized money, youre going to see gold go up and eventually, if were not careful, it could go to infinity according to a statement Ron Paul made this week.

Thats why now is the perfect time to check out Tony Sagamis new investor presentation about his near-bullet-proof trading system. In fact, Tonys model told him to get out of gold back in November a move that could have saved you from practically all of golds decline.

Click this link now to see how his system can work in any market, and any type of account!

Internal Sponsorship

Is the Risk is Worth the Potential Reward?

To their credit, fund firms that offer open-end mutual funds and ETFs leveraged in absolute (amplifying an upward move) or inverse (that is, profiting from a down move) terms tend to emphasize that their offerings work best over short holding periods.

When you do your research on these funds, youll see words and phrases such as daily and for a single day permeating their literature. That is intentional on their part they are clearly telling you that these are trading vehicles and that longer-term investors should probably look elsewhere.

If you are able to be near your computer when you buy a leveraged ETF, and can take quick action to grab gains when you see them, you are likely to find that results over short time periods tend to behave fairly consistently with the stated intentions.

Longer term, however, even small deviations over time can compound to seriously distort results.

How Leveraged, Inverse ETFs Work and Work Together

For example, the ProShares Ultra Financials ETF (UYG) seeks daily results that correspond to twice the daily performance of the Dow Jones U.S. Financials Index. (Ultra is usually code for double you may also see other funds use 2X to mean the same thing.)

So if financials go up by $1, the UYG seeks to return $2 for that move.

There are also leveraged inverse ETFs. Think of cars on a highway theyre going different directions, but the cars work the same on both sides of the median.

If the UYG is traveling north, then the ProShares UltraShort Financials ETF (SKF) is heading south. The SKF aims to replicate, before fees and expenses, twice the inverse daily performance of the Dow Jones U.S. Financials Index.

As you can see, one is a bet on the Financials Index going up, and the other bets on it going down. Using these leveraged funds, youll likely see a return more-quickly than investors in a non-leveraged fund and thats why its important to pick the right direction from the outset.

You can see a fast return, all right it just might not be the one you wanted!

How These Financial ETFs Were Set to Perform

Stock-picking (and ETF-picking) is all about getting the direction right. With leveraged and inverse ETFs, you have to be pretty spot-on in your directional call and be ready to grab gains or cut losses when the move takes place.

Now, you dont need to station yourself at your computer when you buy one of these instruments. But you should be aware that these cars are powered by jet fuel, so you shouldnt take your eye off of them for long periods of time.

Lets look a little closer at how the financials are performing overall, and how these particular funds have fared to date.

Over the five-year period ended May 31 of this year, the Dow Jones U.S. Financials Index retreated at an annualized rate of 0.31%.

Both UYG and SKF have recently achieved success over periods as long as several months. But as ProShares repeatedly implies in its literature, these funds are not appropriate for longer-term investing. (Forgive my repetition here I cannot stress this enough.)

A 2X-inverse leveraged fund tracking the financial index, theoretically, should have advanced at an annual pace of about 0.62% per year (less fees and expenses). So, then, a 2X-leveraged fund should have retreated at roughly 0.62% annually before fees and expenses.

And How They Actually Performed

And now for the actual five-year results

Long-side-leveraged UYG saw an annualized loss of 19.58%. And the ultra-short-geared SKF realized an ugly 44.69% annualized setback for the past five years.

Thats right, both the long-side-leveraged and the short-leveraged sank drastically over the long term.

Wasnt one of them supposed to go up when the other retreated?

That isnt an indictment of the management capability of ProShares, which meticulously stresses that these ETFs are intended to adhere to their mandates only for daily time horizons.

However

It is a crucial lesson that long-side or short-side leveraged mutual funds and ETFs are not appropriate as long-term investments!

With Leverage, Less is More

Both in Time and in Money Spent!

Im a fan of leverage in the right situations. In fact, my Global Trend Trader subscribers are in two leveraged plays right now.

In the recent absence of any positive news on economic growth in China, I recently recommended a position in a short China fund a deliberate move to profit from erosion in one the worlds biggest economies. (Full disclosure: I recommended grabbing gains yesterday.)

Now, unlike much of Wall Street, Im not bearish on China overall. As we discussed last week, China has two economies and right now it makes sense to be bullish on one and bearish on the other.

As the U.S. financial ETFs have shown us, even diversified ETFs can produce unanticipated results. No investment outcome is guaranteed, whether youre using leverage or not leverage simply serves to enhance your winnings or your losses.

Another reason to pay close attention to these kinds of ETFs is because many of them are actively managed.

The bulk of ETFs are passively managed that is, the stocks and those stocks allocations are changed infrequently and, therefore, their fees are kept in check. But actively managed funds can see a relative high turnover of the investments contained within them and that also tends to result in higher fees for the individual investor.

Bottom line: Leverage isnt for everyone, and its perfectly OK to stay away from it unless or until you are absolutely comfortable with the potential risks-vs.-rewards they present.

I am a firm believer that ETFs should be part of every investors arsenal. If investing in stocks is like owning a good set of knives, then ETFs are like having some really good appliances that you can plug in, turn on and basically let them do some of the work for you.

ETFs with leverage, then, might be more like that fancy food processor that you really wanted but might not fully know how to use yet. It doesnt mean that you wont but it does mean that maybe youll want to use the instructions before attempting a more-sophisticated dish!

If youre looking for some expert guidance, my friend Tony Sagami is getting ready to release four ETF recommendations in his International ETF Trader service early next week. Hes discovered a remarkable indicator that can identify which are about to rise or fall. And the push-button system hes created isnt influenced by headlines or any other factors beyond the quality of the investments themselves. You can learn more about it here.

Best wishes,

Rudy

Rudy Martin, editor of Global Trend Trader. is the President at Acamar Global Investments, with 25 years of experience serving institutions and high net-worth individuals.

Rudy started his investment career in 1983, co-managing a $2 billion private investment portfolio for Transamerica. Later, he went on to Wall Street as an equity analyst for Dean Witter and traveled globally, serving major institutional equity investors. In 1995, he joined Fidelity Investments as a Senior Investment Analyst for a series of multibillion-dollar fund portfolios.

During his career, Rudy has received awards for institutional investing and is widely quoted in the financial press and on television about topics related to global investing and emerging markets. For more information on Global Trend Trader click here.