Is the Backlash against Leveraged ETFs Warranted?

• By Ron DeLegge, Editor
• On 1:09 pm EDT, Friday July 31, 2009

SAN DIEGO (ETFguide.com) - If you haven't heard yet, sales of leveraged and short ETFs at major brokerage firms like Ameriprise, Edward Jones, LPL Financial and UBS have been either halted or banned. Other firms are mulling whether to follow suit. At issue is whether investors and financial professionals clearly understand these specialized investment products.

How do they work?

Leveraged and short ETFs attempt to magnify their gains and to provide inverse market performance to various stock, bond and commodity indexes on a daily basis. Because they aim to achieve investment results that target the daily returns of their underlying benchmarks, they're best suited for investors with a short-term time horizon.

One example of this is the Direxion Daily Emerging Markets Bull 3x Shares (NYSEArca: EDC - News) which aims to deliver three times the DAILY performance of emerging market stocks within the MSCI Emerging Markets Index. If this particular benchmark increases in value by 1% on any given day, EDC tries to obtain a 3% gain. If emerging market stocks decline by 1% on any given day, EDC should fall by 3%.

Despite striking a chord with a certain demographic and amassing billions of dollars over a very short time frame, leveraged ETFs have become the financial services industry's punching bag.

Is the backlash against leveraged and short ETFs warranted?

Contradictions and More Contradictions

Isn't it a colossal paradox the brokerage firms that are quick to ban leveraged and short ETFs are still OK with sub-standard investment products that systematically underperform the market? Such products typically come in the form of active mutual funds sold under the premise of getting 'long-term' performance. They have lots of loads, lots of fees, lots of taxes and thus, carry lots of underperformance.

How many financial atrocities have been committed in the name of obtaining long-term performance? I'm guessing roughly the same number of atrocities committed in the name of obtaining short term performance.

But never mind any of that.

Here's another question that deserves an answer: Are any of the advisors at these brokerage firms still allowed to sell hedge funds or investment products that use long/short or leveraged strategies? Does anybody know? And if the sale of these investments has not been halted or banned like it has for leveraged and short ETFs, why?

Financial regulators might want to look into this matter to determine if the brokerage firms that are banning the sale of leverage and short ETFs are consistent with the investment advice they're giving to their clients. Double standards and contradictions in financial advice should not be tolerated. 

What is the 'Right Thing' for Investors?

This may come as a surprise to most of Wall Street's brokers, but 100% of investors don't necessarily have a long-term investment time horizon. And by halting or banning short-term investment products like leveraged ETFs, certain brokerage firms are sending an unmistakable message they don't want anything to do with people that have short-term investment objectives. If you're a client with short term goals and this doesn't make you feel a tad-bit uncomfortable, then you either don't have a pulse or you're not paying attention.

Knowing whether leveraged and short ETFs are right for you is a very simple exercise that boils down to three main factors: 1) Your investment time horizon, 2) Your risk tolerance, and 3) Whether these type of investments match up with your broader investment goals.

 Any investments you decide to buy should always be compatible with your ultimate investment objectives. This is true for any type of investment, leveraged and short ETFs included. 

Distorting the Market?

Blaming short ETFs for falling stock prices has become a popular argument. In April, CNBC's main mascot Jim Cramer complained the ProShares UltraShort Financials ETF (NYSEArca: SKF - News) was being used by aggressive short sellers to 'pound bank stocks down.'

If it's true that short ETFs are indeed creating distorted stock prices, shouldn't it be reflected in asset imbalances between funds that go long and short the same stocks?

For example, how can ETFs that short financial stocks like the ProShares UltraShort Financials Fund (NYSEArca: SKF - News) be the culprits for falling share prices when leveraged ETFs that are long the very same financial stocks like the ProShares Ultra Financial Fund (NYSEArca: UYG - News) have their short counterparts outsized by almost two-to-one?

A similar pattern of leveraged long ETFs dwarfing the assets of their short (opposite) counterparts is also visible with other ETFs like the ProShares Ultra Technology Fund (NYSEArca: ROM - News) and ProShares UltraShort Technology Fund (NYSEArca: REW - News) along with the ProShares Ultra HealthCare Fund (NYSEArca: RXL - News) and the ProShares UltraShort HealthCare Fund (NYSEArca: RXD - News).

Stop Talking and Start Regulating

Isn't it time regulators stopped issuing empty press releases about leveraged ETFs and started regulating? One would think so.

If financial regulators really want to do something productive and meaningfully important for the investing public's benefit, they should begin by forcing providers of short and leveraged ETFs to properly label their financial products in a uniform manner.

To this end, Direxion Shares recently changed the name of its entire lineup of leveraged and short ETFs to reflect the word 'Daily.' Without a doubt, this was a leadership move by the Boston, MA-based fund company designed to help investors clearly understand that Direxion Shares attempt to deliver DAILY leveraged and inverse returns of their underlying indexes.

Thus far, Direxion has been the only ETF provider in this category to take corrective action to properly label its financial products. Isn't it time for regulators to take preemptive action by forcing ProShares, Rydex Investments and other providers of leveraged and inverse ETFs and ETNs to insert the word 'Daily' into all of their product names?

How much longer will financial regulators allow the use of mislabeled financial products? Aren't regulators to blame, at least in part, for allowing such mislabeled financial products to exist in the first place? In this regard, uniformity in how products are named should become an immediate priority.

Conclusion

Since touching March lows, US stocks (NYSEArca: VTI - News) and international stocks (NYSEArca: VEA - News) have rallied 48% and 60% respectively. Emerging market stocks (NYSEArca: EEM - News) have soared by some 80%. If your advisor works for one of the brokerage firms that's banned or halted the usage of short ETFs, ask them how they plan to protect any market gains you have. If they try to sell you something instead of answering your question, I think you know what to do.   

In a recent podcast Finra said, 'Leveraged and inverse ETFs can be appropriate if recommended as part of a sophisticated trading strategy that will be closely monitored by a financial professional.' 

Ultimately, each individual needs to determine how much of a role short and leveraged ETFs will play inside their investment portfolios. However, don't be bamboozled by the false arguments and other financial propaganda surrounding these products.

Who knows, they might even help you to successfully deal with the market's next correction.

Buzz up!