Leveraged and inverse ETFs: What's the fuss?

Advisers wonder why these exchange-traded funds suddenly have become toxic

Sep 9, 2009 @ 12:01 am

By Dan Jamieson

As leveraged and inverse exchange-traded funds have come under attack, some advisers wonder what all the fuss is about.

True, not all do-it-yourself investors and even advisers, for that matter, fully understand how the products are reset each day to track their underlying indexes.

But that ignorance is not the fault of the industry, advisers said.

“I feel that the industry has done its job” in explaining the products, said Robert Kargenian, founder of TABR Capital Management LLC, with $144 million under management.

“It's the people using them who haven't taken the time to understand them,” he said.

The Financial Industry Regulatory Authority Inc. triggered a wave of concern about leveraged and inverse ETFs in June when it issued a warning about using the products for longer than one day.

Due to the daily resetting by the products, and the effects of compounding, the sequence of returns is critical, advisers said.

“However, because of all volatility we've seen, if you did buy and hold for an extended period, [the products] didn't always correlate” to the underlying index, said Tom Lydon, president of Global Trends Investments, who manages $79 million.

ETF providers have always explained how the daily resets work, he said.

Leverage funds have done “exactly as advertised,” said Eric Leake chief investment officer at Anchor Capital Management Group Inc., which manages about $360 million.

The volatility of both up and down days has “greatly amplified” what, on the surface, look to be large tracking errors, he said.

“If we'd had a straight compounding move in one direction [like the market moving] down 1% per day” to produce a 50% loss, inverse ETFs would have “worked perfectly,” Mr. Leake said.

ETF providers don't know who their shareholders are, so it's not known how many buyers of leveraged and inverse funds are unsophisticated do-it-yourselfers.

Leveraged funds often end up on the top of performance lists and get a lot of attention, Mr. Lydon said.

“It could be that those [investors] who got the greedies and didn't do their homework may have gotten involved,” he said.

In addition, although advisers may understand how to use the products, that “doesn't always mean they'll be on the right side of the market,” Mr. Lydon said.

Making a wrong-way bet on market direction, or giving up profits with a hedge, doesn't always endear advisers to their clients, he said.

At least one provider, the Direxion Funds, plans to move some products to a monthly reset.

In early July, Direxion filed with the Securities and Exchange Commission a request to change the tracking on its open-end leveraged and inverse funds to a monthly basis, said Bill Franca, executive vice president of distribution at Direxion.

The change would reduce the number of compounding periods, to 12 a year, he said.

The change by Direxion is a good move that “will better reflect investor behavior,” Mr. Leake said.

In the meantime, advisers hope the dust-up over non-traditional ETFs will die down.

“I understand regulators trying to get their arms around [the products] a little more,” Mr. Lydon said. But now that the warning has been made, “the heat will back off of this,” he said.

Mr. Leake thinks liquidation of inverse funds in the wake of the regulatory scare has helped fuel the market rally as hedges have been unwound.

He thinks regulators are trying to look tough after missing the Bernard L. Madoff and Allen Stanford frauds.

“ETFs are not the worst things that have happened to the securities industry,” Mr. Lydon said.

0
Comments

What do you think?

View comments

Recommended for you

Upcoming Event

Apr 30

Conference

Retirement Income Summit

Join InvestmentNews at the 12th annual Retirement Income Summit - the industry's premier retirement planning conference.Much has changed - and much remains to be learned. Attend and discuss how the future is full of opportunity for ... Learn more

Featured video

Events

What makes now an ideal time to talk about philanthropy?

With the end of the year approaching, advisers need to be thinking about charitable giving. Schwab's Kim Laughton and JMG's Melissa Walsh discuss some new opportunities to consider.

Latest news & opinion

Raymond James executives call on industry to keep broker protocol

Also ask firms to pay for the administration of the protocol to 'ensure its longevity and relevance.'

Senate committee approves tax plan but full passage not assured

Several Republican senators expressed reservations about the bill, and the GOP cannot afford too many defections.

House passes tax bill, focus turns to Senate

Tax reform legislation expected to have more of a challenge in upper chamber.

SEC enforcement of advisers drops in Trump era

The agency pursued 82 cases against advisers and firms in fiscal year 2017, down from 98 the previous year.

PIABA accuses Finra of conflicts of interest

Public Investors Arbitration Bar Association report slams self-regulator over its picks for board of governors.

X

Subscribe and Save 60%

Premium Access
Print + Digital

Learn more
Subscribe to Print