The Fight Over the Riskiest Investments on Earth

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With more than $1 trillion invested in exchange-traded funds, the stakes for the companies that manage those assets are monumental. So with a Congressional committee hearing serving as a convenient opening, the giant in the ETF industry has taken the opportunity to try to squash what's become an increasingly popular competitor.

Leveraged ETFs inspire intense debate among ordinary investors. While some see them as a great way to take maximum advantage of short-term trends in the market, others note the potential for big losses if ETF shareholders don't use them correctly. Later in the article, we'll take a look at whether investors are using leveraged ETFs in the manner they were intended. But first, let's go ringside to see two of the industry's biggest players in their ongoing fight about ETFs.

Let the battle royale begin
In one corner, you'll find Larry Fink, CEO of BlackRock (NYSE: BLK  ) , the company behind ETF giant iShares. According to Fink, the core purpose of ETFs should be to give general exposure to different stock indexes and sectors of the financial markets. In that light, leveraged ETFs don't meet his definition of what an ETF really is -- because they introduce leverage in a way that creates a potential structural problem that traditional ETFs don't have to deal with. Fink said he was surprised that regulators like the SEC even approved leveraged ETFs in the first place -- especially in light of other overleveraged situations that have come back to bite investors in other arenas of the market, particularly high-debt financial institutions like MF Global. He suggested forcing leveraged funds to give up their ETF name.

Fighting against iShares are leveraged ETF providers like Direxion and ProShares, both of which have large and popular leveraged ETFs. ProShare Advisors CEO Michael Sapir called the BlackRock proposal "anticompetitive" as a backhanded way to attack iShares competitors without iShares having to make any changes itself. Further, leveraged ETF managers would prefer to continue attempting to educate investors about the characteristics of the funds, viewing that as being more beneficial than eliminating or limiting their use arbitrarily.

Let the bell ring
So which side has it right? One key issue to address is whether investors are actually using leveraged ETFs the way they were intended: as very short-term investment vehicles for playing discrete trends in the markets.

For a clue to that, you can look at investor turnover of leveraged ETFs. If shareholders are buying and selling their ETF shares on a daily basis, as their calculation methods would suggest is the most appropriate strategy, then you'd expect to see average daily dollar trading volume to approach the total assets under management of the ETF. On the other hand, if volumes are considerably less, then it suggests that investors are holding on to their shares much longer.

As you'd expect, different ETFs get used for different purposes. With silver ETFs ProShares Ultra Silver (AMEX: AGQ  ) and ProShares UltraShort Silver (AMEX: ZSL  ) as well as the broader-market bear fund ProShares UltraShort S&P 500 (AMEX: SDS  ) , the entire asset base of the funds turn over roughly every two trading days. The bearish Direxion Daily Financial Bear 3x (AMEX: FAZ  ) rotates even more quickly, with average volume actually exceeding assets under management recently.

Interestingly, though, some bullish funds had slower turnover rates. In particular, financial-focused Direxion Daily Financial Bull 3x (AMEX: FAS  ) and ProShares Ultra Financials (AMEX: UYG  ) both had turnover periods between five and eight trading days. That may not seem like long, but it's an eternity in the fast-paced trading world of ETFs. Even the unleveraged benchmark SPDR S&P 500 ETF turns over every three days or so.

It's a draw
In the end, whether you think leveraged ETFs should have to ditch the exchange-traded fund moniker depends on your opinion of how much investors need protection from regulators. The companies that sell leveraged ETFs have been as clear as they possibly can be about how these ETFs work. At some point, it's up to you to make an informed, rational decision about whether leveraged ETFs deserve a place in your portfolio.

What's certain, though, is that a simple name-change won't have any material impact. If regulators really don't like leveraged ETFs, they shouldn't seek out an unsatisfying compromise. Rather, they should outlaw leveraged ETFs entirely and let the chips fall where they may.

ETF investors don't need leverage to earn strong returns. Take a look at The Motley Fool's free special report on ETFs and get some names you can truly count on.

Fool contributor Dan Caplinger fondly remembers watching pro wrestling as a kid. You can follow him on Twitter here. He doesn't own shares of the funds mentioned in this article. The Motley Fool has sold short shares of SPDR S&P 500. Motley Fool newsletter services have recommended buying shares of BlackRock. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Fool's disclosure policy stands up to bullies.

Read/Post Comments (4) | Recommend This Article (3)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On November 17, 2011, at 11:43 AM, bonesrmybus wrote:

    The ETF industry is a welcome development in the industry.

    It reminds me of the late 1960's when Mutual funds were the new product that were being examined and thought to be a product that may have risks.

    All investing is risk taking.

    Mutual funds are used for most of Americans, either directly or indirectly through retirement plans, financial consultants, municipalities, on and on.

    With easy access to information and education provided by the mutual fund industry, I believe that the majority of people still have no idea of there holdings or exposure.

    ETF's are ideal for an investor that takes the time to try and learn the market.

    I have welcomed ETF's in my trading and plan to continue in the future.

  • Report this Comment On November 18, 2011, at 4:43 PM, rfaramir wrote:

    Government intruding by force and dictating what investors can and cannot buy is always detrimental. These ETFs are welcome for their specific purposes.

    Beware that fraud is equivalent to force as a manner of stealing someone's private property. Educate yourself about these before investing, and warn off those around you if it looks like they're more interested than prepared. Be part of the free market police to ensure that these things are not sold under false pretenses.

  • Report this Comment On November 19, 2011, at 7:29 AM, skypilot2005 wrote:

    + rec

  • Report this Comment On November 19, 2011, at 6:03 PM, rlm2002 wrote:

    Leveraged ETFs can be held for long terms in directional markets. I bought UYG, UYM and others in April 2009, held until March 2011, and did great!

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