I alluded to this in a post about shorting the Euro, and the comments by readers had misinformation, so I thought I’d clarify.
As I understand it, I typical leveraged short ETF fund is structured so that its return is based on the percentage daily increase or decrease in the price of the underlying securities.
So let’s say you invest $100 in a “triple short” fund that focuses on the Panamanian stock market. Let’s examine two scenarios.
The day you buy the fund, the market goes up 20%, which means your holdings decline 60%, which means your holdings are now worth forty dollars. The next day, the market declines 16.67%, losing the previous days gains, which means that your holdings rise 50% to sixty dollars. Uggh! The market has been neutral after a two-day period but you have lost forty dollars.
But let’s say the reverse happens. On day one, the market goes down 20%, so you now have $160. But the next day, the market regains its losses, rising 25%. That means that your holdings fall 75%, and are now worth only forty dollars. Double Uggh!
In short, if you hold long-term and the market simply stays steady over time despite daily ups and downs, you lose your shirt (albeit not as quickly as in my example with dramatic daily moves). This also means that even if your short bet is correct, and the value of the underlying securities falls, you will at best not make nearly as much money as you might think, and you might even take a loss. Which is why professional traders know what they are doing only use these funds for day trading. [I, on the other hand, learned this the hard way.]
UPDATE: Here’s an academic paper on the subject.