Absurd Inverse and Leveraged ETF Product Whining (Updated)

by: David Fry

Editor's Note: This post was updated to reflect new developments in this sphere of the ETF industry. Its original publication date was June 28, 2009.

I’m a fan of these products, and am glad ProShares, Direxion, Rydex and PowerShares (via Deutsche Bank) have made them available. But like any other security or product, these issues need to be used properly.

When used correctly, they allow individual investors and advisors the opportunity to hedge and/or add more potential return to index-based securities.

An avalanche of complaints have been made recently by those taking the most egregious form of leveraged product use - buy and hold - to tar the entire levered ETF group negatively.

Sure, given the nature of how these products function, including within periods of high volatility and compounding issue complexity, they don’t achieve what some mistakenly believe is their job. But, this is not their proper use — period.

Leveraged issues should be used strategically and tactically by experienced investors over short periods of time, which may include day-trading and time periods of just a few weeks. To accomplish performance goals and achieve success, a disciplined and systematic approach is essential.

Commodity and currency markets have been difficult sectors for retail or financial advisors to participate in due to high entry costs for commodity pools and hedge funds, high ongoing fees and expenses, and even greater leverage than most investors are comfortable with. The introduction of ETF products in this area has given investors the opportunity to participate in markets previously unavailable to them. Trends in these market sectors can change quickly, and participating successfully in them therefore requires the careful application of trading methodologies. That’s what the most sophisticated investors in this sector do—they trade.

Have issuers done a great job of explaining this to the investing public? Probably not, but they’re working on it and so is the SEC, thanks to new education notices issued by FINRA (pdf).

Unleveraged inverse ETF products are a blessing to those investors wishing to avoid losing 40-50 percent of their portfolio’s asset value due to the occasional but devastating bear market, such as we’ve recently experienced. They don’t have the large tracking errors the whiners have ascribed to the entire product group.

Why shouldn’t retail investors and financial advisors be able to hedge or protect their own or their clients’ portfolios through the use of leveraged and inverse products?

Most complaints have come from those with inherent product conflicts. Jack Bogle hates ETFs. Nate Most (a wonderful gentleman now deceased) created the ETF while working for the American Stock Exchange. Excitedly, he took his baby to his friend Jack Bogle to see what he thought of his new product idea. Bogle’s response? “You mean investors can buy and sell these things intraday?” For a paternalistic buy-and-hold aficionado, the very idea was heretical! Since then, Bogle’s old shop, Vanguard, has jumped into the ETF fray with both feet, which must cause him great consternation.

Others simply don’t like the idea of short-selling - like our friend Jim Cramer, who routinely and theatrically describes leveraged products as “evil”. But when he was operating his hedge fund, Cramer shorted stocks routinely – and, to hear him tell the story, made money at it. Why shouldn’t you? Further, by his own admission, Cramer’s contract with CNBC actually prohibits him from short-selling.

Cramers and others have whined that they want the uptick rule reinstated to protect stocks and indexes from being attacked by short-sellers. This is a red herring, in my opinion. You can watch the tape on any trading day where sectors and stocks are being pummeled, and within even the shortest time frame, you’ll note plenty of upticks along the way down.

And, speaking of smoke-screens and red herrings, now Edward Jones is prohibiting its clients and advisors from trading in leveraged ETF products. It sounds paternalistic on the surface but masks the real agenda—they don’t want clients deviating from their high-fee plans sold to the masses door-to-door.

Many investors, retail and institutional alike, are day-trading leveraged ETFs. Whether they’re successful or not isn’t the issue. Many of these products are horning in on the action for options and futures traders. After all, options have caused more investor complaints and hardship than any ETF, leveraged or not. As a former options principal, I can say with authority that understanding options strategies is more complex and confusing than grasping the proper use of any ETF product.

Other ETF-haters include many in the mutual fund industry, especially those tied to the exorbitant fees generated and so-called “evergreen” income earned. In fact, it was the scandals caused within the mutual fund industry in 2002 and 2003 that turned investors to ETFs in the first place. ETFs have proven disruptive to costly business models, and those dependent on them, don’t like the growing ETF market one bit.

Are there poorly constructed, bad or ineffective ETFs? Sure, and they’ll be winnowed out and disappear over time. But their number pales in comparison to the many worthless mutual funds still being issued and tormenting holders.

Those promoting individual stocks dislike the growing ETF market because most recent asset flows have been to ETFs and not single-stock issues. No wonder those guys are upset!

Leveraged and unleveraged inverse ETF products allow sophisticated retail investors and financial advisors the ability to construct hedge fund-like strategies for themselves and their clients that were heretofore unavailable for these investors. ETF products exist to protect investors from the carnage of bear markets and to provide opportunity to profit in bull markets. So who in the hell are Jack Bogle, Jim Cramer, and now Edward Jones to tell such investors they shouldn’t or can’t have this protection, or benefit from these opportunities?

And, of course, regulators with little else to do, jump on the pile. State agencies are under pressure to justify their existence and defend their budget allocations in this era of poor municipal revenues. State regulators can be the most uninformed pests amid the regulatory environment. Witness the State of Massachusetts Attorney General John Galvin who is launching an investigation into leveraged ETFs and their marketing practices. It’s hard to imagine they’re not doing that with the more volatile and dangerous options markets. This guy is just grandstanding sensing a microphone and TV camera near. Anyway, the SEC is already on the case and they’re cracking down on sales practices making the Massachusetts effort redundant.

Despite the few--but loud-- naysayers, these products will continue to be used by thoughtful and disciplined investors to achieve portfolio protection and profit opportunity.