Restricting Access to Leveraged ETFs - Are Brokerages Outlawing Products or Strategies?

As more brokerages prevent their customers (read: individual investors) from trading leveraged ETFs, I am moved to question the motivation of these firms.

Thus far, we have UBS, Edward Jones, LPL Financial and Ameriprise Financial all banning trading of ETFs from ProShares and Direxion. Moreover, the Massachusetts chief financial regulator has announced an investigation of leveraged ETFs.

Further stirring the pot, FINRA issued a warning that these ETFs are not suitable for investors who hold them for longer than one day. If they are held longer than a day they would only be appropriate if "closely monitored by a financial professional."

The evidence against leveraged ETFs --

The beef against these ETFs is that you can get the call on a sector or index correct and still lose money. The examples used over and over again are the ProShares UltraShort Financial ETF (SKF) and the ProShares UltraShort Real Estate ETF (SRS). Despite the financial and real estate sectors taking a dive in 2008, an investor who held these ETFs for the entire year would have lost money rather than achieving a comfortable gain.

Then there are the 3X ETFs from Direxion. The products do indeed exhibit some extreme behavior and are probably best suited for very brief trades.

The implications --

The defenders of leveraged ETFs are many. Their main argument is that an appropriate strategy is necessary in order to make money with these ETFs. Sure, they work for day traders and swing traders but the evidence also exists that when a solid trend is underway and volatility is moderate to low, the 2X ETFs can easily be held for weeks or months; ie, as long as the trend is in force. And the profits under such conditions can be substantial. (In fact, those conditions are prevalent in the market right now.)

Uh oh. Trend followers are essentially the same as market timers. It is a generally accepted truth among financial advisors that market timing isn't appropriate for individual investors. Or is it?

Has there ever been a brokerage that discouraged market timers or day traders? Right or wrong, market timers and day traders generate commissions and commissions are the lifeblood of a brokerage.

So brokerages attack leveraged ETFs with a big dose of hypocrisy. If I am a lousy market timer, it’s OK to squander my funds on stocks, options or standard ETFs but it's not OK to lose my money on leveraged ETFs.

Are brokerages banning day trading or market timing? Never happen. Even though there is plenty of evidence that many individual investors are not particularly adept at these trading strategies.

Will brokerages ban leveraged ETFs to make it look like they actually have the best interests of investors in mind? After more than a year where so many financial advisors failed to help investors avoid steep losses, this move is a cynical attempt to detract investor attention from the fact that brokerages did little or nothing to guide or protect investors during the worst market downturn in decades. This is hypocrisy, not protection for investors.

As 2-Pac used to say: "In a position to make a difference, politicians and hypocrites they don't wanna listen."

Disclosure: long ROM, USD and UYG

Comments

[kkerr:]

I agree with all of your points. It is my belief that they are being banned due to investors' lack of understanding of how they work for periods longer than a day. With a stock at least investors know there is no potential for loss from some weird 'decay.' However, the counter argument is that options are not trivial to understand either, and they are not banned. Hence, leveraged ETFs should not be banned.

Aug 04 09:09 AM

[GadflyOnThe...:]

I also agree with all your points. As far as SRS, Ultrashort Real Estate, I have this on my watch list in order to discern if it is a tradeable security. So far, I have been disappointed with its movement, therefore I do not trade it. And this is the key to these leveraged ETFs, indeed, with any security, be it an ETF (1x, 2x, 3x, short, long), stock, option, mutual fund, Closed end funds ... an investor in these should study them and know what they are getting into. Obviously, the brokerage firms that are banning these ETFs have either investors who do not study the investments and/or their brokers are too lazy to educate their clients and/or (as a former stockbroker, I have experienced this), the brokers are too lazy/stupid to learn about these securities themselves. Remember, brokers are not sophisticated financial people, but just salespeople.

Aug 04 09:53 AM

[Lawrence J....:]

The investor needs to pass a simple, one question test: If the relative index goes up 5% on Monday and returns to base on Tuesday, where does you ETF end up ? If he says "where I started," he can't buy the thing. Since that test is impractical to administer, and something like 90% (my guess) of retail investors would fail it, maybe pessimists should just be limited to buying puts.

Aug 04 10:45 AM

[MarkitWacha:]

I'm disappointed in SRS. Long-term Put options are better, but you can't trade those from within a 401k portfolio.

If there was some way that rolling put options could be packaged and securitized and traded within 401k plans, the leveraged ETFs wouldn't be so controversial.

Long: TBT

Aug 04 12:59 PM

[User 272317:]

when were the warning labels "dont hold for more than a day" added to the prospectus of these products??? I dont remember reading that -- though the fine print on these may have changed later. How this product was presented when put on the market -- specifically aimed at 401k holders that had no other shorting options!!! ---is that it was designed to give you a 2 or 3x times gain against the movement of that market. The risk of holding for more than a day or two was fraudulently misrepresented (if mentioned at all), nor were the technical aspects readily apparent to even sophisticated investors (as is the case with many of these leveraged products), and that is clearly why the Mass. financ. reg is stepping in.
its true that this is way too late for the brokerages to step in and say "sorry" to individual investors who got hosed (including myself). but it will be entirely appropriate for the SEC to come in and whack these products. Undoubtedly, the reason brokerages are stepping in to cut off a product that they sell and make a ton of fees on (since trading in and out of these products is the only way to make it work) is because they simply do not perform as represented broadly in the prospectus.

Aug 06 05:12 AM