Leveraged ETFs to Hedge Portfolio

This idea was introduced to me when reading The Big Picture the other day. He was talking about how they had been investing 50% of the portfolio using 2x levered S&P ETFs and leaving the other 50% in cash. So in essence he had 100% exposure to the market but was able to maintain a 50% cash allocation. On the surface this seems like a very good and easy way for small individual investors to hedge their portfolios. You have full exposure to the market but are still earning 3% or whatever current Money Market rates are on 50% of your portfolio regardless of market performance. I am very intrigued by this idea but know very little about leveraged ETFs. How do the funds go about levering themselves? What are the unique risks to these types of funds not found in standard ETFs? What are the fee structures like? What happens if the index it is tracking falls more than 50% after you invest in it? Do you end up having to fork more money over? The way I see it you could take this a step further and invest 33% in a 3x levered fund and keep 66% in cash or bonds. Or you could use that 33% or 50% to invest in a certain industry short ETF. Or you could play with the allocations and basically come up with a quasi 130/30 or something similar strategy. Which brings up another question. How do the mechanics of a short ETF work? You invest money in the fund but what does the fund do with that cash? Does anyone have any good places to look to research how these funds work. What do you think about these strategies as a whole? I bet with all the smart people here we could come up with some interesting ideas.

They just invest in derivatives - usually swaps or futures contracts. You aren’t getting a free ride of course and you should expect the 2x leveraged ETF + 50% in cash to perform the same as a half-collateralized investment in futures contracts (i.e., you pay for leverage here just like you would anywhere else). If the index drops by > 50% then all your money is eaten and they have closed out the derivatives positions and your ETF is worth nothing. You don’t have to come up with more money. It still would suck. Short ETF’s work the same way except you are on the other side of the derivative contract.