Leveraged exchange-traded funds (ETFs) are under fire. Along with inverse ETFs, leveraged ETFs are the subject of a recent notice from the Financial Industry Regulatory Authority (FINRA) reminding brokers and registered investment advisers that these ETFs are unsuitable to be held by most investors for more than a single trading session due to their complex nature.

Leveraged ETFs
This reminder speaks to the nature of these products. Consider leveraged ETFs, which are designed to follow daily changes in stock market indexes. A leveraged ETF with a 2:1 ratio uses financial derivatives and debt to match each dollar of investor capital with an additional dollar of invested debt. If one day the underlying index returns 1%, the fund will theoretically return 2%. While the upside potential is what most brokerage firms tout, the same theory applies for losses. (For additional insight into how these products work, read Dissecting Leveraged ETF Returns and Rebound Quickly With Leveraged ETFs.)

Inverse ETFs
Inverse ETFs use derivatives to create a similar effect, by betting against the direction of the financial markets. Known as "short" or "bear" ETFs, these products are designed to make money if markets decline. Marketed as a way to reduce your exposure to market risk or enhance portfolio performance, they an also have the exact opposite effect on performance if markets move against the bet. (To learn more about them, read Inverse ETFs Can Lift A Falling Portfolio.)

Legal Action
These complicated, sophisticated investment products have been successfully mass marketed. Not millions or tens of millions, but billions of dollars are now invested in them according to the Wall Street Journal.

In response to FINRA reminder, the state of Massachusetts has gone on the offensive, sending subpoenas to four firms that sell these products in that state and requesting the names of accountholders and details regarding the purchase, such as whether or not the sale was solicited. As a result, all four firms have halted sales of leveraged ETFs and some have gone so far as to send letters to their self-directed brokerage clients suggesting that they sell their positions if they have held them longer than a single day. If Massachusetts scores a settlement from these firms, other cash-strapped states are sure to follow with subpoenas of their own.

In Defense
ProShares, a big player in this space continues to defend the products, correctly pointing out that retail investors routinely purchase sophisticated investment products. While that sentiment is correct, it doesn't mean that the investors actually know what they are doing or if they should be doing it. Of course, nobody was making these investors buy.

The End of Leveraged and Inverse ETFs?
Whether the money to be made or lost in such sophisticated products is the spoils of victory from a little risk-taking or the punishment for buying products without actually understanding them, the current political environment doesn't bode well for the providers of these products. With massive stock market losses fresh in everyone's mind and regulatory oversight under fire for its complete failure to protect the public from securities fraud on a massive scale in a string of high-profile scandals from Enron to Madoff, the smart money might place an inverse bet on the future of these products. Even if they survive the hit, they may have reached their high-water mark in terms of market penetration.

Related Articles
  1. Investing Basics

    Top Tips for Diversifying with Exotic Currencies

    Is there an opportunity in exotic currencies right now, or are you safer sticking to the major ones?
  2. Mutual Funds & ETFs

    The 3 Biggest Mutual Fund Companies in the US

    Compare and contrast the rise of America's big three institutional asset managers: BlackRock Funds, The Vanguard Group and State Street Global Advisors.
  3. Stock Analysis

    The Biggest Risks of Investing in Boeing Stock

    Learn about the biggest risks faced by Boeing investors. How should investors think about cyclicality, debt, sales volumes and customer concentration?
  4. Professionals

    5 Top-Rated Funds for Your Retirement Portfolio

    Mutual funds are a good choice for emotional investors. Here are five popular funds to consider.
  5. Mutual Funds & ETFs

    The 4 Best Buy-and-Hold ETFs

    Explore detailed analyses of the top buy-and-hold exchange traded funds, and learn about their characteristics, statistics and suitability.
  6. Chart Advisor

    Bumpy Roads Ahead In Transportation

    Investors are keeping an eye on the transportation industry. We'll take a look at the trend direction and how to trade it.
  7. Investing

    How ETFs May Save You Thousands

    Being vigilant about the amount you pay and what you get for is important, but adding ETFs into the investment mix fits well with a value-seeking nature.
  8. Mutual Funds & ETFs

    3 Fixed Income ETFs in the Mining Sector

    Learn about the top three metals and mining exchange-traded funds (ETFs), and explore analyses of their characteristics and how investors can benefit from these ETFs.
  9. Chart Advisor

    Agriculture Commodities Are In The Bear's Sights

    Agriculture stocks have experienced strong moves higher over recent weeks, but chart patterns on sugar, corn and wheat are suggesting the moves could be short lived.
  10. Investing News

    Top Tips for Diversifying with Mutual Funds

    Are mutual funds becoming obsolete? If they have something to offer, which funds should you consider for diversification?
  1. Can mutual funds invest in IPOs?

    Mutual funds can invest in initial public offerings (IPOS). However, most mutual funds have bylaws that prevent them from ... Read Full Answer >>
  2. What is the utility function and how is it calculated?

    In economics, utility function is an important concept that measures preferences over a set of goods and services. Utility ... Read Full Answer >>
  3. Does index trading increase market vulnerability?

    The rise of index trading may increase the overall vulnerability of the stock market due to increased correlations between ... Read Full Answer >>
  4. What does a high turnover ratio signify for an investment fund?

    If an investment fund has a high turnover ratio, it indicates it replaces most or all of its holdings over a one-year period. ... Read Full Answer >>
  5. What is the difference between passive and active asset management?

    Asset management utilizes two main investment strategies that can be used to generate returns: active asset management and ... Read Full Answer >>
  6. What does a futures contract cost?

    The value of a futures contract is derived from the cash value of the underlying asset. While a futures contract may have ... Read Full Answer >>

You May Also Like

Hot Definitions
  1. Section 1231 Property

    A tax term relating to depreciable business property that has been held for over a year. Section 1231 property includes buildings, ...
  2. Term Deposit

    A deposit held at a financial institution that has a fixed term, and guarantees return of principal.
  3. Zero-Sum Game

    A situation in which one person’s gain is equivalent to another’s loss, so that the net change in wealth or benefit is zero. ...
  4. Capitalization Rate

    The rate of return on a real estate investment property based on the income that the property is expected to generate.
  5. Gross Profit

    A company's total revenue (equivalent to total sales) minus the cost of goods sold. Gross profit is the profit a company ...
  6. Revenue

    The amount of money that a company actually receives during a specific period, including discounts and deductions for returned ...
Trading Center
You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!