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Leveraged ETFs & Calls for More Regulation: Caveat Emptor

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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.”

More on this topic

Executives at BlackRock and Invesco PowerShares are now calling on regulators to address and increase suitability requirements for the sale of sophisticated ETFs, such as leveraged funds.

Academics, legal analystsand hired guns for plaintiffs’ lawyers have also weighed in questioning their wisdom to various extents. 

However (in Forbes), William Baldwin (like Marc Gersteinbefore him) defends their use over the longer term even while recognizing their inherent risks because “they outperform during trends” (assuming anyone is capable of spotting trends with a significant degree of success). 

Moreover, Murray Coleman (in Barron’s) provides a qualified endorsement and reports that Jeffrey Kleintop, the chief market strategist at LPL Financial, has added a small portion to client portfolios in order to try to increase returns.

It should be clear, then, that leveraged ETFs are dangerous and can readily be unsuitable, especially for retail investors and buy-and-hold investors.  That said, they can also be an appropriate trading tool and needn’t be limited to one-day holding periods.

Even though I agree with Barry Ritholtz that the big moves into these funds are likely misplaced, that isn’t a basis to impede the use of this type of fund. Risk isn’t necessarily a bad thing and concerns as to how a product is used and how it is sold don’t necessarily require adding layers of regulation to the investment process. 

In my view, the primary answer to how markets should approach and regulate risk is with transparency, full disclosure and education

There are instances where I think it makes sense to put up safeguards and roadblocks to protect investors – primarily from themselves.  But based upon the evidence at least so far, the availability of leveraged ETFs isn’t one of them.

Further experience may cause me to change my stance.  But my default position of advocating their being allowed like nearly any other investment vehicle remains intact.

Further study and monitoring is surely warranted.  But for now, as with any purchase, it should be enough to let the buyer beware.