As the economy begins to find its footing and the immediate panic of the financial crisis subsides, investors and regulators alike are starting to look back and take a closer look at what went wrong in our financial system. While we all have some idea about where the breakdowns occurred, the more important issue is to figure out how we can learn from our mistakes and perhaps prevent another crisis in the future. And not surprisingly, some folks at the top are zeroing in on one area of the market that could be at risk.
Under the microscope
The Securities and Exchange Commission recently announced that they would undertake a review of derivatives-based funds to determine whether additional investor protections are needed. This move could have wide-ranging effects on many exchange-traded funds that use derivatives to create leveraged portfolios. Leveraged investments have come under increased scrutiny in recent months, which could have a negative impact on their demand in the market if additional regulations are implemented.
Personally, I'm glad to see the increased focus on leveraged and inverse ETFs. I've long advised investors against buying these types of funds, which are usually better suited to gambling than investing. Time will tell whether the SEC will take a hard line with these leveraged funds, but in the meantime, you can stay one step ahead of the regulators and rule these risky investments out of your portfolio.
If there's a segment of the market that can be sliced, diced, and leveraged to the hilt, ETF providers will no doubt find a way to market it to you. For example, some believe that energy stocks are poised to continue rising, with oil prices having seen big jumps since early last year. If you think energy stocks will rise, you can buy the Direxion Daily Energy Bull 3X Shares (NYSE: ERX ) , which offers you three times the daily return of the Russell 1000 Energy Index.
But a look at the fund's holdings shows just how leveraged and reliant on derivatives it is. A swap on the Russell 1000 Energy Index Fund accounts for over 200% of assets. The largest holdings in actual energy companies are ExxonMobil and Chevron, which only account for 20.6% and 9.4% of assets, respectively.
Investing in these funds can actually be riskier than most people realize. Because these funds typically track the daily return of their respective index, that means profits or losses may be magnified and can be much greater or much less than the annual returns of the benchmark. And that's on top of an already leveraged portfolio.
Besides, how many investors really need a fund that offers three times the inverse of the daily performance of the semiconductor market? Unless you're speculating and looking to make a quick buck, this kind of investment just doesn't make sense for the vast majority of folks.
Jacking up the price
Aside from the fact that leveraged and leveraged inverse ETFs are simply too risky and unnecessary for almost all investors, they simply aren't cost-effective. The more complex and exotic the fund, the more expensive it typically is. The Direxion fund mentioned above has an expense ratio of 0.94%. That's more expensive than a good number of actively managed funds! And when you consider that the broad-market SPDR S&P 500 ETF (NYSE: SPY ) clocks in with a rock-bottom 0.09% price tag, leveraged and inverse leveraged funds just don't look like good long-term investments.
If you're a fan of low-cost, passive investing, make sure you stick to well-diversified ETFs and leave the leveraging to the speculators. A broad-market fund like Vanguard Total Stock Market ETF (NYSE: VTI ) works well for full market coverage because it includes stocks of all sizes. If you want to drill down on small-cap stocks exclusively, the iShares Russell 2000 Index (NYSE: IWM ) is a good choice at a reasonable cost. Bond investors should try out the iShares Barclays Aggregate Bond Index (NYSE: AGG ) , which offers exposure to Treasuries, agency bonds, mortgage-backed securities, and corporate bonds.
Besides, if you really want to speculate on a particular sector, you don't need leverage. For instance, in the example above, energy sector funds like Energy Select Sector SPDR (NYSE: XLE ) and iShares Dow Jones US Energy ETF (NYSE: IYE ) are more expensive than most broad-based ETFs, but at 0.21% and 0.47% respectively, they're still quite a bit cheaper than their leveraged counterparts.
While I'm gratified to see leveraged ETFs under the regulatory spotlight, as long as even a small number of them continue to post impressive returns, there will be investors who will be lured to them like a moth to a flame. My hope is that, at the very least, with the SEC scrutiny more investors will get the message that these investments are risky and hopefully think twice before placing their bets.