From the May 2010 issue of Investment Advisor • Subscribe!

Soapbox: Debunking the Myths of Leveraged ETFs

As a relatively new and unique investment tool, leveraged exchange traded funds are often misunderstood. These funds have experienced such tremendous growth in recent years that it's generated controversy about whether investors truly understand what they're getting into.

Yes, as an executive with a company that offers such ETFs I am biased, but that's why I believe that for advisors, the potential benefits of leveraged ETFs rest on gaining a thorough understanding of how leveraged funds work and separating fact from myth. This is especially true considering that regulators have expressed concerns about how and when financial advisors should recommend leveraged ETFs for their clients. Leveraged and inverse ETFs are powerful investment tools that serve a very specialized purpose: meeting the investment demands of a small portion of sophisticated investors.

First, let's consider the context. In the summer of 2009, the controversy surrounding ETFs seemed to come to a head as heightened scrutiny forced a number of investment products under a regulatory microscope. At the root of the problem was the fact that unlike traditional, buy-and-hold unleveraged funds, leveraged ETFs seek daily returns, not returns over the long haul.

This gets to the first common myth about leveraged ETFs: they are inherently flawed because they aren't appropriate for buy-and-hold investors. The reality is that trying to judge the performance of leveraged ETFs over a long period of time reflects a fundamental misunderstanding of what leveraged funds are intended to do, as well as how they are used. In general, most leveraged ETFs seek daily or monthly investment returns and are among the most liquid in the marketplace. They're meant to be used as part of an active investment strategy, which sophisticated investors--from day traders to institutions--routinely employ. Just because they serve a different purpose from traditional ETFs and mutual funds doesn't mean they're flawed: it means they occupy a different market niche.

That isn't to say that leveraged ETFs aren't suitable for investors who plan to hold them for more than a single day--another often-heard myth. Investors determine the timing of a purchase or sale of a leveraged ETF based on several factors including the fund's goals and performance characteristics, as well as current market conditions, risk tolerance, and overall portfolio composition. Depending on these variables, an advisor or investor might indeed decide to hold an ETF for periods longer than a single day, perhaps even for weeks or months, as part of a sophisticated, tactical investment strategy. If held for such periods, however, it is imperative that these positions be monitored very regularly, like daily.

More than $30 billion has been raised in leveraged index ETFs in the last two years. Given this, it's certainly reasonable to wonder whether this growth is sustainable. You might even find in this a final myth about leveraged ETFs: Traditionally most investors have had a strategic, long-term prospective mindset, so what future is there for investment products aimed at short- and mid-term, tactical strategies?

In truth, in today's environment, with so much access to information and technology, a growing portion of the investment community wants to trade actively and invest tactically. By and large, this isn't the mom-and-pop investment community. This is institutions, endowments, pensions, corporations, and other sophisticated investors that seek to take advantage of market volatility with actively managed portfolio strategies.

Leveraged ETFs are products well suited to serve this portion of the marketplace. While future growth may not continue at the same rates as seen in 2008 and 2009, steady organic growth seems likely, which would provide even more reasons for sophisticated investors to develop a sound understanding of leveraged ETFs and use them effectively in their portfolios. By separating leverage ETF fact from fiction, advisors and investors can at least decide for themselves if this product is right for them.

Andy O'Rourke

Senior VP

Direxionfunds

Newton, Massachusetts

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