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February 16, 2011 at 11:29 AM
When an investment vehicle is misunderstood, misused or mis-sold, there are often knee-jerk reaction calls for more regulation or even the elimination of the product type.
Take leveraged ETFs, for example.
In recent years, exchange traded funds have grown immensely in popularity – for many good reasons.
ETFs have attractive characteristics and provide individual investors with a simple way to gain sector or broad market exposure at a reasonable cost.
But leveraged ETFs haven’t gotten the same positive buzz. These vehicles purport to provide two or three times the returns of an index by using a combination of swaps and other derivatives. And they do, but only technically and only sort of – and that’s the cause of the problem.
Leveraged ETFs are designed to provide a multiple of the return of the applicable index or the inverse thereof, but only for a single day (as their marketing literature is typically careful to point out).
Because these daily returns are compounded, the returns of leveraged ETFs over periods longer than one day will likely differ in amount and maybe even direction from the target return for the same period.
This slippage from their targets typically ranges from 200 to 500 basis points — the longer the time held, the greater the potential slippage. They don’t quite do what many consumers assume they will do.
As a consequence, the SEC and FINRA have published notices warning that “inverse and leveraged ETFs that are reset daily typically are unsuitable for retail investors who plan to hold them for longer than one trading session, particularly in volatile markets.”
On the FINRA website, regulators subsequently softened their stance somewhat: "Leveraged and inverse ETFs can be appropriate if recommended as part of a sophisticated trading strategy that will be closely monitored by a financial professional. At times, this trading strategy might require a leveraged or inverse ETF to be held longer than one day."
However, the size of such funds and the speed with which they are growing suggest that they are used far more broadly than the “recommended daily allowance.”
