Leveraged, Short ETFs Under Attack

In Figure 2, let’s suppose the index declines in value by 5 percent the following day. Over the entire two-day period the index has lost 0.25 percent. However, the performance for both leveraged ETFs over the same two-day period produces much greater losses of negative 17.25 percent and negative 2.25 percent. This example illustrates how the returns of leveraged ETFs are much more exaggerated and dramatic than their underlying indexes.

Let’s assume the same pattern of returns (positive 5 percent one day followed by negative 5 percent the following day) for 30 consecutive days. At the end of 30 days, the index lost 3.69 percent. Interestingly, while both the leveraged long and leveraged short ETFs have opposite daily goals, they both finish the 30 day period with the same 28.92 percent loss.

On July 27, the SEC adopted Rule 204T to eliminate what it called “abusive” naked short selling. With normal short selling, traders borrow stock and sell it, hoping to profit by purchasing the shares later at lower prices and collecting the difference. In naked short selling, traders generate sell orders on stocks without borrowing the shares. While the actual impact of naked short selling on the broader market is not known, the new ban ends share delivery failures and the operational headaches they caused.

The SEC’s Rule 204T for naked short selling does not apply to market makers involved in legitimate hedging, nor does it apply to leveraged short ETFs.

“The ban will not impact leveraged index funds at all as they do not short single names and never engaged in naked shorting of any kind,” said Daniel O’Neill, chief investment officer at Direxion Funds, sponsor of the Direxion Shares ETFs. He continued, “Leveraged index funds do not have direct short positions — they use index derivatives to get exposure.”

Wall Street Reaction

The negative publicity surrounding them still hasn’t quelled investor’s appetite for leveraged and short ETFs.

At the end of June, the two largest providers of these specialized ETFs (ProShares and Direxion Shares) amassed $30.2 billion in such funds.

Despite soaring assets and popularity among active traders, a number of brokerage firms like Ameriprise, Edward Jones, LPL Financial, Morgan Stanley and UBS have either banned or temporarily halted the sale of leveraged ETFs. Firms say this stance against leveraged ETFs is because they aren’t compatible with the long-term investment objectives of their clients.

One untouched issue is the consistency of investment advice coming from Wall Street brokerages. Have the same brokerage firms that have publicly stopped the usage of leveraged ETFs taken a similar stance against other leveraged products, like hedge funds, closed-end funds and structured products? And if not, why? Shouldn’t all leveraged products get the same sort of treatment?

For example, it’s a widely known fact that leveraged ETFs are used by many hedge fund managers. Wouldn’t it be sinister irony if brokerage firms are still allowing their advisors to recommend hedge funds that are using banned leveraged ETFs? Such inconsistencies should be addressed at the firm level and perhaps even at the regulatory level. Double standards should not be allowed to exist.

Finally, in an August regulatory alert, FINRA said, “The best form of investor protection is to clearly understand leveraged or inverse ETFs before investing in them.”

It’s hard to disagree.