by Tim P. on 2009-10-25 3

The word leverage gets some people excited, while it makes others nervous. No surprise since its just a word that represents higher risk, higher reward. Our contributing writer, Tim Parker from Elementary Finance. talks about leveraged ETFs and how you can use them to spice up your investment portfolio.

What Is Leverage?

Id like to bring up a word that you may not use much: Leverage. Heres a fairly simple definition: leverage refers to multiplying something you already have. I have legs that allow me to move but I can “leverage” the speed of my movement by traveling in some sort of vehicle. For instance, I can get somewhere faster by riding an airplane. I can get to where I’m going in a fraction of the time this way.

But if I want to fly faster using a device (on my own) that can leverage my speed, Im going to have to learn how to use that device. Trying to fly a plane without the sufficient knowledge to operate it can certainly be a huge risk and a dangerous endeavor; doing so would just be plain foolish.

Fun ICanHasCheezburger photo.

The same thing is true when you try to use leverage in the field of finance. We all have heard that it takes money to make money, and on the surface, its true. Lets take for example the case of a typical part time retail investor who would probably invest, at the most, $2,000 into one stock position. Given historical long term stock market returns, it would be realistic to think that he could make 10% or so with his investment on an annual basis. A 10% return on his stock position yields around $200. That is certainly nothing to sneeze at but it isn’t going to change anyones standard of living, at least not until that 10% return multiplies itself many times over.

Now heres the thing, there are many ways to multiply that return many times over you can go on margin with your investments, but its something that takes a tremendous amount of risk, which to me, boils down to making a gamble. Theres also the wait and see (or buy and hold ) approach: over time, investments go up in value in a market uptrend, their returns multiplied as a consequence of the power of compounding. But if you arent necessarily interested in borrowing from your broker in order to purchase securities (via margin) but you feel that you can afford to take on some risk to give your portfolio that extra nudge, then theres a way to leverage by simply relying on the right stock picks you make.

By using a little money to make a lot of money, youll be able to “leverage” what you already have. This is possible with a type of exchange traded fund called a leveraged ETF. Let’s look at one of my favorites:

Leveraged ETF Investing: More Risk With More Reward

The ProShares Ultra Dow (DDM) is a leveraged exchange traded fund that moves at twice the rate of the Dow Jones Industrial Average. If the Dow moves up 1%, this ETF moves up 2%. If the Dow has a great day and moves up 3%, youll make 6% in one day! Quite a nice way to invest, isn’t it? Here is a tidy list of Ultra ProShares Leveraged ETFs that tracks the whole spectrum of indexes (and more):