Leveraged ETFs: Worst Investment Ever

10/27/2011 11:47 am EST

Focus: ETFS

Howard Gold

Founder & President, GoldenEgg Investing

Like most investments that hold the promise of quick riches, geared funds seem better than they often are, and investors who buy and hold these things do so at extreme peril, writes MoneyShow.com editor-at-large Howard R. Gold.

Exchange traded funds have been a great boon to investors, offering them cheap, easy access to broad indexes and asset classes they could never invest in directly before.

So it’s no wonder ETFs now account for $1 trillion in investor assets.

But along with the boom have come many dubious products that allow investors to “play” assets like palladium, marginal currencies like the Russian ruble, and countries like Belgium and Peru.

And then there are leveraged ETFs.

Leveraged ETFs purport to give investors two or three times the return of the underlying indexes on which they’re based. Inverse leveraged ETFs let you do the same thing on the short side.

The problem is, these instruments are designed to be used as daily hedging and trading vehicles. But investors are holding them much longer than a day, which is particularly dicey in today’s volatile markets.

That’s why I think these are the single worst product for individual investors I’ve seen in two decades of covering markets.

There are plenty of other ways investors can hedge their portfolios with less risk, like using certain simple options strategies. Successful investing in leveraged funds requires the discipline of a computer-driven hedge fund or a steely eyed professional trader. Using them improperly is all too easy.

Because of this, I think it’s time for regulators to impose stricter suitability standards on these vehicles for individual investors, especially in retirement accounts—and if I thought it would work, I would support banning them entirely.

Leveraged ETFs have blossomed like poison mushrooms, and now account for about $40 billion in investor assets, about half of that in inverse leveraged funds. They cover many asset classes: gold, natural gas, the euro…what have you.

They were growing quickly until summer 2009, when the Financial Industry Regulatory Authority (FINRA) called for tighter disclosure requirements for these funds. The Securities and Exchange Commission joined FINRA in putting out a warning to investors who planned to hold them for more than a day.

That’s around when firms like UBS, Ameriprise Financial, and Bank of America Merrill Lynch limited their trading in the controversial instruments.

Indeed, according to a lawsuit filed in US District Court in Manhattan, holding leveraged ETFs over longer periods is highly unlikely to produce the results investors expect, because of these products’ very design.

The plaintiffs are investors in ETFs issued by ProShares Advisors, the largest provider of leveraged ETFs. (Direxion Funds and Rydex SGI are also big players, but they’re not named as defendants.) The investors are seeking class-action status, and a judge is scheduled to hear ProShares’ motion to dismiss the suit next week.

The suit concerns alleged lack of disclosure by the company from 2006 to 2009, when the plaintiffs claim they owned these ETFs. I’ll leave that for the court to sort out, but the case is a fascinating look at how these ETFs work.

Investors who participated in this suit held shares in leveraged ETFs for days, weeks, or months, and some say they lost tens of thousands or hundreds of thousands of dollars.

In a statement, ProShares called the allegations “wholly without merit.” The company claimed its disclosure “has always been accurate and complete” and “complied with all legal requirements.” It vowed to “defend against this suit vigorously.”

Now, these investors are suing, so you’d expect them to have big losses. And they bought these ETFs during the nastiest, most volatile period we’ve seen recently, 2008 and early 2009.

But the structure of leveraged funds makes it extremely likely that investors who hold them for more than a day will lose money, even if the market goes their way.

Why? Because leveraged ETFs use swaps, futures, and other derivatives to return two or three times the underlying index (or two or three times opposite that index’s movements) on a daily basis.

NEXT: Daily Rebalancing, Long-Term Pain

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That daily rebalancing “requires leveraged and inverse ETF portfolio managers to buy at the end of days when the underlying market is up and sell at the end of days when the market is down,” wrote researchers Ilan Guedj, Ghohua Li, and Craig McCann of the Securities Litigation & Consulting Group in The Journal of Index Investing in 2010.

This daily rebalancing could have “the effect of repeatedly buying high and selling low,” their study said. “The more volatile the daily returns, the greater the losses suffered by leveraged and inverse ETFs…”

For example, they wrote, from November 6, 2008 through June 3, 2010, “the Russell 1000 Financial Services Index gained 10%…Yet FAS, the (3X) leveraged ETF, rather than returning 30%, lost 724%, and the (-3X) inverse leveraged ETF, FAZ, rather than losing 30%, lost 97.9% (italics added).”

This “is common for leveraged and inverse ETFs and results from the daily rebalancing of the funds’ portfolios,” the authors wrote.

So, even if you’re lucky enough to get the direction of the market right—a big if—you could still wind up deep in a hole.

“Not only will the magnitude of your returns bounce around, you might not even get returns that are in the same direction as the changes in the index,” wrote Paul Justice, Morningstar’s director of ETF Research, in a prescient January 2009 article called “Warning: Leveraged and Inverse ETFs Kill Portfolios.”

In fact, he continued, you are “mathematically guaranteed to get a return that is not double that of the index.” That’s some product!

“The audience it would really be suitable for are professional investors dealing with fund flows on a daily basis,” Justice told me in an interview—that’s “less than 1%” of investors. Asked whether they’re appropriate for individuals, he answered, “no.”

FINRA agrees. “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,” it said in a September 2009 statement that also required fund companies to tighten their disclosures and sales practices.

Was that enough? I don’t think so. I’ve dealt with thousands of investors over the years, and too many of them are easily drawn into manias and speculation, as we had in silver and inverse silver ETFs back in April.

You can’t prevent that, and indeed there are many vehicles investors can use to speculate to their hearts’ content but are not guaranteed to miss their stated return over time, as Justice said leveraged ETFs are.

If I believed regulators could vet these things properly, I’d support banning leveraged funds and some other exotic ETFs outright for individual investors, just as we ban tainted pharmaceuticals or toys with lead paint from China. (Yes, I think they’re that bad.)

But I don’t think FINRA or the SEC is up to the job. (Since 2010, the SEC has been reviewing funds’ use of derivatives.) Nor do I have any faith in Congress to tackle this, as Chuck Jaffe has written.

Justice instead favors more extensive disclosure and consent decrees that make “you have to legally sign an agreement” before you buy these instruments. That’s just what I did when I wanted to trade options in my Fidelity IRA, and it makes sense for leveraged ETFs, too.

“Geared ETFs…have been used successfully by many investors to help manage risk or pursue returns,” said ProShares’ chief executive officer Michael Sapir in a statement. “We continue to focus on educating investors and advisors about geared funds. It is not in our interest for anyone who does not understand geared funds to use them.”

Education is a good thing, but all the education in the world won’t make leveraged ETFs good for investors. So, until the regulators start doing their jobs, I’d avoid these things like the plague.

Howard R. Gold is editor at large for MoneyShow.com and a columnist for MarketWatch. Follow him on Twitter @howardrgold, read more commentary at www.howardrgold.com, and catch his political blog at www.independentagenda.com.

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