The Danger of Trading Certain ETFs

09/28/2010 12:01 am EST

Focus: ETFS

David Penn

Editor-in-Chief, TradingMarkets

Leveraged (two or three times market movement) and inverse ETF products have exploded to over 120 with $30 billion in assets since October 2009.

They have become among the highest traded securities in history. For example, the Wall Street Journal reported that Direxion Financial Bear 3x Shares (FAZ) traded 23 million shares on February 25, 2009, with only two million shares issued at the time. One can extrapolate that the holding time averaged just 34 minutes. Major problems arose during 2009 with these new products. Several produced returns the opposite of what they were designed to do, while others greatly disappointed investors with lackluster performance over the longer-term.

Basically, many investors did not read the fine print stating that the returns are daily based on the underlying instruments. As in any leveraged instrument, daily rebalancing is required to keep the product tracking the underlying. It is due to this rebalancing that the cumulative returns do not match the daily returns. In other words, if you hold leveraged ETFs for more than a day, some unexpected and even crazy things can happen.

As you could expect with such a popular product, the regulators quickly began to issue warnings about the suitability of these volatile shares for retail investors who plan on holding for more than one day. In June 2009, FINRA issued a notice stating that they are generally unsuitable for retail investors. However, they quickly refined this broad statement in July 2009 stating, in part, that some sophisticated trading strategies may require leveraged or inverse ETFs to be held longer than a day.

In fact, regulators have ramped up their investigation to such a degree that four large financial institutions have been subpoenaed to reveal their leveraged/inverse ETF marketing materials. In August, the SEC and FINRA issued an alert warning investors that the daily return objectives do not match the longer-term returns of the products. Steps were taken in December 2009 to increase the margin requirements for investors using margin to buy leveraged or inverse ETFs. Whenever there is some confusion and money involved, lawsuits can be expected. More than a few class actions suits have been filed due to the misleading marketing of these securities.

Academics and regulators are still debating the suitability of leveraged or inverse ETFs for retail investors. Some are of the opinion that they are far inferior to other leveraged tools such as derivatives. While others insist they are a solid product for informed, sophisticated investors.

Regardless of the disparity of opinion, these products remain ultra popular among investors. Studies have been done seeming to indicate that these instruments can be held profitably over the time. One method suggested that longer-term investors need to monitor both the cumulative underlying return and the funds return. If these returns start to diverge, portfolio alterations need to take place once a certain percentage of separation occurs.

Despite the issues, some exciting changes are on the near horizon. For instance, Direxion is looking to market leveraged ETFs that rebalance monthly instead of daily. The fact remains that these instruments have their place but need to be fully understood or the pleasure of investing will quickly turn to the pain of loss.

By David Penn of TradingMarkets.com.

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