Why the SEC Is Warning Investors About Leveraged ETFs

When it comes to complicated, confusing financial products, Exchange-Traded Funds that use derivatives -- products such as options that derive their value from other instruments -- probably top the list. Known as inverse and leveraged ETFs, these funds are tricky not just for the average investor, but also some financial advisers.

In fact, regulators are now beginning to warn retail investors of the risks associated with investing in these highly complex financial products. At the end of last summer, the Financial Industry Regulatory Authority (FINRA) and the Securities and Exchange Commission (SEC) issued an investor alert, Leveraged and Inverse ETFs: Specialized Products with Extra Risks for Buy-and-Hold Investors. Reports that Goldman Sachs (GS) may not have been totally forthright about the risks of a complicated investment may put further pressure on authorities to publicize the risks of certain investments.

In late March, the SEC announced it would conduct a review to evaluate the use of derivatives by ETFs, mutual funds and other investment companies. The review will examine whether additional protections are necessary for those funds under the Investment Company Act of 1940. Of course, the use of leveraged financial instruments are partly to blame for getting us into the latest financial crisis as these products weren't always sufficiently backed by capital.

SEC Is Concerned About Risk

Simply put, until the SEC completes its review, there is a freeze on any new ETFs, futures, options and other instruments that use derivatives. Such instruments that already are in the pipeline will lie dormant until the review is finished. However, the deferral does not apply to existing ETFs or other types of fund applications.

The SEC seems to be concerned that investors in these funds don't understand the additional risks. They are perfectly correct: plenty of investors obviously don't know what they are getting into, Ron Rowland, president of Capital Cities Asset Management wrote on Investwithedge.com. That's why they get angry and file lawsuits after they lose money, despite the many warnings and disclosures they apparently ignore.

The SEC's move is unlikely to have an immediate impact, but could pose a long-term problem for providers, according to Rowland. "Sponsors who have built their business around leveraged, inverse and commodity-based ETFs, are particularly vulnerable since almost all such funds depend on various kinds of derivatives to execute their strategies. This category includes Direxion, ProShares, Rydex, and several smaller funds."

New Restrictions Are Expected

Rowland's best guess is that the SEC, following its review, will allow ETFs to continue using derivatives, though maybe with some new restrictions and additional disclosures. "Meanwhile, we probably won't see any new leveraged, inverse, or commodity-based ETF launches.

Exchange-Traded Notes (ETNs) fall into a different category, so we may see sponsors switch to that format in some cases," Rowland estimates. To get a handle on an ETN, think of it as an senior, unsubordinated debt security. They are structured products. They are debt securities, not equities -- you are buying a promise.

Simply put, says Michael Feser, president of Zecco, an online broker, "This could be a big deal if the SEC chooses to crack down on popular ETFs that use derivatives like leveraged and inverse ETFs. It's too early to say without any indication of the proposed rules."

ETF Providers Are Anxious

No doubt ETF providers are anxiously awaiting the outcome. "We're not terribly pleased about this," says Andy O'Rourke, senior vice president and marketing director for Direxion, a major player in the leveraged ETF space. "We have a product that we would like to roll out, but it has be put on hold now."

The firm can continue with its 2X and 3X funds, which means they seek to deliver the inverse of the performance of the underlying index double the opposite and triple the opposite, respectively. It can also add those type of new products. But if it wanted to introduce a 4X fund, a product that is four times the opposite of its underlying index, that would be problematic now, says O'Rourke. "This could hurt innovation in products that involve derivatives," he says. "Other providers likely have other products in the pipeline that will now be put on hold."

So what is it about leveraged ETFs that makes some heads spin? For a little background, leveraged ETFs seek to deliver multiples of the performance of the index or benchmark they track. Inverse ETFs (also called "short funds") seek to deliver the opposite of the performance of the index or benchmark they track.

Broad to Sector-Specific Funds

Like traditional ETFs, some leveraged and inverse ETFs track broad indices, some are sector-specific and others are linked to commodities, currencies, or some other benchmark. Inverse ETFs often are marketed as way for investors to profit from, or at least hedge their exposure to, downward moving markets. Leveraged ETFs (also known as "ultra short" funds) seek to achieve a return that is a multiple of the inverse performance of the underlying index.

An inverse ETF that tracks a particular index, for example, seeks to deliver the inverse of the performance of that index, while a 2X (two times) leveraged inverse ETF seeks to deliver double the opposite of that index's performance.

To accomplish their objectives, leveraged and inverse ETFs pursue a range of investment strategies through the use of swaps, futures contracts, and other derivative instruments. Most leveraged and inverse ETFs "reset" daily, meaning that they are designed to achieve their stated objectives on a daily basis.

Effect Magnified in Volatile Markets

Their performance over longer periods of time -- over weeks or months or years -- can differ significantly from the performance (or inverse of the performance) of their underlying index or benchmark during the same period of time.

This effect can be magnified in volatile markets. An ETF that is set up to deliver twice the performance of a benchmark from the close of trading on Day 1 to the close of trading on Day 2 will not necessarily achieve that goal over weeks, months or years.

Confusing or not, leveraged ETFs continue to launch and assets are growing. Last year, provider ProShares had net inflows of nearly $8 billion, says Steve Cohen, managing director. So your best bet is study up. Know what you're getting.

Not for the Casual Investor

"The essential thing to know about leveraged or inverse ETFs is that any time the market changes direction from one day to the next, the use of leveraged or inverse ETFs will impose a cost on the user by the nature of how they readjust their portfolio from day to day," warns Marvin Appel, author, Higher Returns From Safe Investments. Appel says that many investors believe if they invest in a 2:1 leveraged ETF and the market goes up 10% over some weeks or month, they will make 20% over the period.

But that's not necessarily the case. The 2:1 relationship only holds from one day to the next, Appel says. Investors who expect to be able to magnify or invert market performance over periods of time longer than one day will frequently end up worse than they expected, he adds.

Leveraged and inverse ETFs should be employed for professional traders making bets on a daily basis, not casual investors, says Jonathan Bergman, chief investment officer with Palisades Hudson Asset Management.

Even Advisers Don't Understand Them

These funds are not for rookies, experts say. "They are for someone sophisticated enough to know how they work, who has taken the time to educate themselves on how they work and truly understands that they reset daily and the impact of compounding, and can devote the majority of their time to them," O'Rourke says. "Generally, your average Joe or Jane doesn't fit that description. It's fair to say some advisers and some retail investors don't understand them."

In fact, says Rick Ashburn, investment counsel for Creekside Partners, says his firm sees no private investor portfolio role for ETFs or mutual funds that use large amounts of derivatives. "Accordingly, we have no objections to regulators making it very difficult for promoters to create and sell them to widows and orphans," he says.

However, just because something is complicated, doesn't mean it may not be a worthy investment. "Leveraged/short ETFs allow individual investors to utilize strategies in an ordinary brokerage account or IRA that they otherwise would not be able to use," Appel says. For example, he says, investors would not put an IRA on margin for tax reasons. What's more, investors are not allowed to sell short in their accounts, he adds.

Used as a Hedging Strategy

They can also reduce risk if they are used as part of a hedging strategy, says Brenda Wenning of Wenning Investments. "Consider that having a percentage of your investments in an inverse-leverage ETF can balance losses in the rest of your portfolio if the market drops in value," she says. "As such, they can reduce the overall risk in your portfolio."

While leverage big guns like Direxion, ProShares and Rydex aren't likely to disappear anytime soon, O'Rourke thinks new players will shy away from the leveraged ETF market. "I just hope the SEC deals with this soon and that they keep in mind that there are various types of derivatives," he says. "Those that are straight forward, transparent and not controversial should be handled differently, they shouldn't be put on hold."

But in the meantime, investors and providers alike will just have to wait to see how the SEC changes the leveraged ETF game.