The Case Against Leveraged ETFs

Includes: AMP, UBS
by: Jake Zamansky

It’s an age-old trick: if one’s good, then two’s better. But when it comes to leveraged exchange traded funds or leveraged ETFs and inverse exchange traded funds…that isn’t necessarily the case.

Over the weekend the Wall Street Journal reported that Massachusetts Secretary of the Commonwealth William Galvin sent subpoenas to several top financial firms including Ameriprise (NYSE:AMP), UBS (NYSE:UBS), LPL Financial and Edward Jones.

A leveraged ETF is really just a traditional exchange traded fund on steroids. The returns are goosed, but the losses are magnified as well.

The groundswell of anger surrounding these products has been steadily increasing for a few weeks and we’ve been getting calls from investors interested in pursuing cases after getting stung by these instruments.

FINRA sent a letter to its member firms warning that leveraged ETFs and inverse ETFs were unsuitable for retail investors. A great many other firms have abandoned them as retail products altogether. For his part, Secretary Galvin wants more information about how brokerage firms marketed leveraged ETFs to investors and why so many lost their shirts. According to the article, leveraged and inverse ETFs held $32.8 billion at the end of June, up $11 billion at the start of 2008.

It’s possible, if not likely, that these instruments were sold to investors as a way to hedge against particular portfolio strategies or even as a cheaper alternative to mutual funds. But investors weren’t told exactly how speculative and costly leveraged ETFs were. In fact, to properly use them, investors basically had to bet on what the market would do that day.

Indeed, a buyer of a leveraged or inverse ETF must have the wherewithal to make significantly sophisticated trading decisions everyday based on how the fund’s derivative index performed and guess which way it will move the following day. I know from over 20 years of working with investors that they are notoriously passive and commonly afraid to take corrective measures without the prodding of their financial advisor. For this reason alone this is an unsuitable product.

Leveraged ETFs, and ETFs generally, are also touted for the tax efficiency. While this fact may be true it would have no bearing on a retail investor using a tax-deferred IRA or other tax-deferred accounts (or indeed those who are already tax-exempt).

Finally, another major reason for the deserved outrage is that leveraged ETFs look like low-cost mutual funds that are pegged to a certain index or basket of securities. But in reality they do not track the index like a passively managed mutual fund would. Rather they trade on the open market and “close” everyday and restart.

This aspect of the instruments is important because it compounds the fund’s expenses, which in the case of the leverage ETFs are very high because of the cost of borrowing. On a good day, when the investor guessed right, he or she might get twice the derivative index’s return, less expenses. But on a bad day, the investor takes twice the loss, plus the expenses. So to make up for the loss, the investor needs two days on the upside to make up for the one day loss. For every day an investor bets incorrectly, the expenses compound so the break even point (i.e. the index) gets further and further out of reach.

It’s almost impossible to justify this expense for a retail investor. And a financial advisor or broker cannot say that somehow a leverage ETF is more suitable than a simple index fund. Thus, the likelihood for another barrage of investor cases is very high.