These Investments Just Don't Work

Schemes that offer people the chance to get rich quick never seem to go out of style. And while the market has historically offered investors the chance to earn steady, solid returns over the long haul, some folks just don't want to wait.

That explains the appeal of exchange-traded funds that let you multiply your returns over those of particular indexes or sectors of the market. And while you might think that magnifying your gains could only help your cause in the long run, the reality proves much more disappointing.

Great for short-term plays
What's behind this fundamental misunderstanding of these ETFs? The problem is that while the leveraged ETFs hold themselves out only as delivering on their promises over very short periods of time -- typically a single trading day -- some investors misuse them by holding them for longer periods.

At first, that seems to run counter to the Foolish idea of holding investments for the long run rather than trading frequently. But to be a good long-term holding, an investment has to be designed to be held for a long time -- and that isn't the case for these ETFs.

Heads I win, tails you lose
The results make these ETFs look like a no-win scenario for investors. Consider these returns since the beginning of the year:

Source: Yahoo Finance. As of April 20.

You'd think that by choosing a particular market or sector, you'd at least stand a chance of making a winning bet. But even a relatively short period of a few months is long enough to make an investment that's designed to be held for only a day or so break down from what investors might expect -- and it's quite possible that everyone ends up a loser.

A closer look at how these ETFs work explains a lot. In order to produce magnified returns, these ETFs often use a sophisticated derivative known as a total return swap. The time period of those swaps defines the appropriate holding period for the ETF. Theoretically, it should be possible for an ETF to make transactions that would produce two or three times the annual return of an index or sector -- although it might be more costly for the ETF.

In appealing to short-term investors, though, these ETFs aren't targeting shareholders with that kind of long-term focus. So they really only work well for day traders.

Get what you want
A good sign, though, is that people seem to increasingly understand these trades. One brokerage firm reports that many customers trade in and out of these ETFs in just a matter of hours.

Nevertheless, these ETFs serve as another example of how you have to research every investment decision you make. It's not enough to think you understand how an investment works, or to take a brief glance at the name or description of a particular security. Rather, you need to be diligent in poring over your investments to ensure they'll behave as you expect.

Obviously, everyone would like to make back as quickly as possible some of the money they've lost recently in the market. ETFs that promise double and triple returns, however, don't fit the bill for long-term investors looking to make solid investments. While these ETFs may make a useful tool for short-term traders, you'll be better served sticking to traditional funds and ETFs like the SPDR Trust (NYSE:SPY) ETF -- and the slower but steadier returns they offer over time.

For more on ETF investing, read about:

• What Warren Buffett thinks about ETFs.
• The most expensive ETFs you'll never need.
• ETF investing in a nutshell.