Leverage ETFs in the News…Again

Posted on 06. Aug, 2009 by Kyle Waller

Leveraged ETFs Under Investigation

The Massachusetts Secretary of State, William Galvin, is looking into the marketing of leveraged ETFs and reportedly has written letters to the three biggest players in this market, ProShares, Direxion, and Rydex.

In addition, FINRA, a regulatory agency for brokers and advisors has issued a warning that leveraged ETFs are usually unsuitable for investors who plan to hold them for longer than one day.

At this time, all leveraged ETFs have the objective  to provide a daily short or leveraged position in an index.  The key word is daily and often the returns can vary greatly from that expectation. 

The firms issuing these ETFs are very clear to that point and advise that the funds are only intended to give daily exposure. 

The concern is loses for the Massachusetts Secretary of State, as he wants to determine whether the issuing ETF providers are at fault, leading the unknowing brokers to these kind of products. 

What I think is mostly overlooked and is that FINRA is setting up a situation for brokers to be at fault.

The Distinction

There is a major distinction between brokers and advisors which I believe may surface here.  Brokers should, but aren’t required, to act in client’s best interest, as long as investments are suitable.  An investment is suitable if it makes sense to be in a client’s portfolio-not whether it is the highest quality product or whether it is prudent. 

Advisors on the other hand are required to act in the client’s best interest.  Investments must be suitable, appropriate, and represent the client’s best interest.

Advisors Not Off the Hook

I have looked, with a lot of detail, at leveraged ETFs and the issuing companies and prospectuses are clear that the ETFs will not meet their objective longer than a day.  

With FINRA and other Government agencies catching on to this and looking for someone the blame for major losses investors take in these funds, advisors and brokers who have misused these funds will be soon coming under a lot of heat.

Know Your Investments

Here at Wiser Wealth we have always understood the risks of leveraged ETFs and have been very surprised to see that many of our peers do not. In 2008, if you shorted the S&P 500, you would have actually lost money. How is this possible? The S&P 500’s up days were (in percentages) higher than the down days. Since leveraged ETFs compound daily and the up days had bigger losses than the down day gains, you got the perfect losing recipe.

There have been a few infamous ETFs to bite the dust because of poor design and complex strategies that did not work. Adopting a policy of ”if you cannot explain how the investment works to a client, then it doesn’t make the list”, might be a good idea for professionals that take everything at face value.

Clearly the regulatory authorities understand the leverage risk. Do you?