Leveraged ETFs: Too Risky For Their Own Good?

By Lisa Smith | August 18, 2009 AAA
Leveraged ETFs: Too Risky For Their Own Good?

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.

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