Leveraged ETFs: Handle with care

investment advisers, financial planners and brokers should exercise extra caution before they recommend or guide their clients into leveraged exchange traded funds.

Not only has the Financial Industry Regulatory Authority Inc. warned that such funds typically are unsuitable for retail investors, as reported in InvestmentNews last week, but the secretary of the Commonwealth of Massachusetts, William Galvin, said last week on CNBC that his office is planning to examine the sales practices of such ETFs.

Given the heightened sensitivities of all regulators as a result of the Internet bubble, the mutual fund market-timing scandals and now the mortgage bubble, other state regulators may well get into the act.

The concern of the regulators is that leveraged and inverse ETFs are so complex that retail investors will not easily understand the limitations and dangers of the instruments. Yet there is evidence that they are being marketed in ways that may appeal to retail investors, according to Mr. Galvin.

Therefore it is possible, even likely, that some retail investors will be lured into investments that are not only unsuitable, but even dangerous for the unsophisticated.

Mr. Galvin, like New York- and Washington-based Finra, acknowledged that leveraged and inverse ETFs could be useful investment vehicles, but he noted that they had to be closely monitored.

As Michael Sapir, chairman of ProShare Advisors of Bethesda, Md., the largest provider of such ETFs, told InvestmentNews, investors can use them for more than a day successfully, but the key is to monitor performance carefully. If a leveraged or inverse ETF deviates too far from its benchmark, the investor should take action to reduce exposure.

But that is the rub.

How many retail investors are prepared to monitor an ETF’s performance against its benchmark daily? How many would know when the ETF had deviated from the benchmark far enough for corrective action to be required? How many would know what corrective action to take?

Even if they recognized the need for action, and knew what to do, how many would take that action?

One of the great weaknesses of individual investors is inertia.

Even when they know they should take action, they often fail to do so. They often need to be prodded into action.

How many investment advisers or financial planners will be willing to ride herd on their clients to make sure they are monitoring their positions? How many would take the responsibility for ensuring that clients take appropriate action when a fund deviates from its benchmark?

Any adviser who encourages or allows clients to invest in these exotic ETFs should be prepared to make sure that the clients understand the uses and weaknesses of the investments and monitor them, and be prepared to prod them into action when necessary.

Leveraged and inverse ETFs may well have roles in carefully constructed portfolios of some sophisticated investors, adding additional diversification.

But the regulators are right to be worried that unwary, unsophisticated investors may be lured into the vehicles by marketing messages intended for sophisticated investors.

The Finra warning and the actions of Mr. Galvin in taking a look at the marketing of them are appropriate steps to head off that possibility.