Don Dion: Thoughts on Leveraged ETFs

by: Don Dion
As a starter for our upcoming live discussion on leveraged ETFs (Thursday at 2pm ET), we asked Don a few questions regarding these products:

1) How, if at all, do you use leveraged ETFs in your own portfolios?

We use ETFs to gain very targeted exposure to indices and asset classes, not to build leverage in our portfolios. Other than using single short ETFs for selective periods of time during the crisis, we do not use them as a regular trading strategy.

2) Do you see any significant tactical differences in the approaches of the leveraged ETF providers (ProShares, Direxion, Rydex) in terms of composition or methods of capturing the desired return? Do you prefer certain approaches over others?
ProShares pioneered the single-short ETF universe while Direxion garnered investor interest with triple short investment strategies. There are obvious differences between owning an inverse ETF and owning a triple short ETF. The more highly leveraged products, like those offered by Direxion, are aimed more at professional traders trying to manage intraday exposure. If you look at the notational trading volume numbers and net assets each month, it is apparent that traders are turning over triple-leveraged funds fast.

3) Leveraged ETFs have been scrutinized all over for only being appropriate for short-term traders, due to the daily reset and problem of longer-term compounding. This summer, FINRA issued a direct warning to RIAs about the use of these ETFs in longer-term client portfolios. Do you think the leveraged ETF providers have done an adequate job in explaining these products? And do you think they are commonly misused by RIAs? Misused by retail investors?
Investor education is the most important factor. Following the FINRA warning, leveraged fund issuers dramatically increased the disclosure. Investors look to ETFs for inexpensive, transparent exposure. It is a mistake to lump equity ETFs, ETNs, leveraged funds and futures-based commodity ETFs into one category. Each type of product is different, and each has its own type of risks.
Regulators also have to get their heads together so that there are fewer disruptions in trading.
Derivative-based ETF products should be handled with special care by RIAs and investors. The temptation is to take the names of the funds at face value and not consider the ways that these strategies are executed.
These funds have certainly been misused by investors in the past, but regulators and issuers both seem eager to clear up any misunderstanding.
Again, however, it is important to note the high turnover for these leveraged funds. It is fairly obvious that they are used, most of the time, by professional traders.

4) What are your thoughts on MacroShares' leveraged Housing exchange traded products (DMM, UMM)? Are these likely to face the same issues as the MacroShares oil products? If someone has a large percentage of net worth in home equity, would DMM make sense as a hedge against home prices falling?
These products are pretty similar to the failed oil funds. It's taking money out of one pocket and putting it into the other. There's nothing easy about "shorting housing", so investors should be wary. These funds aren't going to track home prices exactly. I would not use these to hedge net worth in real estate.