Leveraged ETFs Are Going Down

The prospect of doubling or tripling your returns always sounds attractive -- especially when stocks rocket higher, as they have recently. But financial regulators want to clamp down on investments that offer the promise of multiplying your gains.

Understanding leverage
Leveraged ETFs give investors a way to amplify their returns over regular exchange-traded funds. By using swaps and other derivatives, most of these ETFs do a reasonable job of delivering on their promise to rise or fall by an appropriate multiple of the daily return on the indices they track.

The key word to look at, though, is "daily." Leveraged ETFs aren't designed to track their indices for long periods of time, so long-term holders of these securities can suffer losses even when their underlying indexes gain.

Regulators weigh in
That's exactly what the Financial Industry Regulatory Authority (FINRA) points out as problematic. In a regulatory notice from last month, FINRA states that leveraged ETFs "are unsuitable for retail investors who plan to hold them for longer than one trading session, particularly in volatile markets." The implication for brokers is that even if customers want to buy leveraged ETFs, brokers will have to demonstrate that they've given their customers the information necessary to fully understand the risks and terms that leveraged ETFs carry.

In particular, here are two examples of leveraged ETFs that showed what appears to be strange behavior. Over the past year, the ProShares Ultra Oil & Gas Fund (NYSE: DIG  ) lost 78% of its value. That's not terribly surprising, as top index components ExxonMobil, Chevron, and Schlumberger (NYSE: SLB  ) have all lost 20% or more since mid-2008.

Under those conditions, you'd hope that the conversely bearish oil ETF, ProShares UltraShort Oil & Gas (NYSE: DUG  ) , would have made money for investors. But they also lost money, as the ETF fell almost 11%.

Similarly, the popular Direxion Daily Bull Financial 3X (NYSE: FAS  ) ETF has stuck investors with losses of 69% since the beginning of the year, while the Direxion Daily Bear Financial 3X (NYSE: FAZ  ) ETF has clocked in with a drop of 85%. With constituent companies like American Express, JPMorgan Chase, and NYSE Euronext (NYSE: NYX  ) putting in a mixed showing since the year began, it's strange to see such huge drops for both of these funds.

Fighting the crowd
The problem that regulators and brokers potentially face is the overwhelming demand for these leveraged ETFs. Despite having started less than a year ago, the Direxion leveraged financial ETFs together already have over $3.2 billion in assets.

Moreover, that growth has occurred despite the fact that mutual losses on various ETF pairs are increasingly obvious. Direxion announced that it would do a 1-for-5 reverse split on its bull leveraged financial ETF and a 1-for-10 reverse split for the bearish fund -- a move that's necessary given the recent drop in share price.

For the most part, it's hard to argue that anyone has been misled by these funds. Leveraged ETF providers have been as upfront as possible that returns are based on daily index moves, to the point where many of the ETFs involved have the word "daily" in their name.

Nevertheless, regulators often conclude that they have to protect people from certain wealth-destroying investments, even when there's full disclosure. For ETF providers like BlackRock, who may want to use its recent purchase of the iShares family from Barclays (NYSE: BCS  ) as a way to offer innovative new ETF offerings, the threat of increased regulation is not a positive sign.

For investors, though, the move serves as a good reminder of what leveraged ETFs are made for. Unless you're ready and willing to speculate on extremely short-term moves in various stocks or indices, then there's really no reason to use leveraged ETFs at all. If investors can't learn to not hold these vehicles as long-term investments, then the SEC will likely end up making the decision for them.

For more on using funds and ETFs, read about:

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Fool contributor Dan Caplinger wants a leveraged ETF based on how much rain western New England has gotten lately. He doesn't own shares of the companies mentioned. NYSE Euronext is a Motley Fool Rule Breakers recommendation. The Fool owns shares of American Express, which is a Motley Fool Inside Value recommendation. Try any of our Foolish newsletters today, free for 30 days. Don't leverage your integrity; rely on the Fool's disclosure policy.


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  • Report this Comment On July 08, 2009, at 10:16 PM, rudynoir wrote:

    "...it's strange to see such huge drops for both of these funds..."

    It's strange all right, but perfectly normal. These huge drops are a result of decay, and it's a normal mathematical phenomenon that affects all leveraged ETFs. The reason it is more pronounced with FAZ/FAS is due to their volatility. The more volatility, the faster the decay occurs.

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