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1-pager: Leveraged and inverse ETFs on the ropes

|Includes: iShares S&P GSCI Commodity-Indexed Trust ETF (GSG)

Summary

Regulators have their sights set on restructuring the market for leveraged, inverse(short) and commodity ETFs.  Increased scrutiny for these index shorts and leveraged bets have the ETF industry running for cover and it’s already impacting existing shares in common ETFs tracking commodities and sectors, like Oil and Financials.  Advisers commonly use these products for hedging or sector themes and were spooked earlier this week when Deutsche Bank’s Power Shares announced it was shuttering the PowerShares DB Crude Oil Double Long Exchange Traded Note, an exchange traded note (NYSE:ETN) tracking 2x the change in oil prices.  Here’s what’s going and what you need to know.

History
  • 6/2009: FINRA issues a notice reminding firms and brokers that “recommendations to customers must be suitable and based on a full understanding of the terms and features of the product recommended; sales materials related to leveraged and inverse ETFs must be fair and accurate; and firms must
    have adequate supervisory procedures in place to ensure that these obligations are met.”
  • 8/18/09: Finra issues an investor alert entitled: Leveraged and Inverse ETFs: Specialized Products with Extra Risks for Buy-and-Hold Investors specifically aimed at warning retail investors of the risks associated with investing in leveraged and inverse index securities.
  • 8/19/2009: The U.S. Commodity Futures Trading Commission (CFTC) said that it withdrew exemptions it had granted two Deutsche Bank commodity ETFs years ago on speculative limits on corn and wheat contracts setting up as it commits to investigating speculation in the commodities market via exchange traded securities.
  • 8/27/2009: UBS joins Edward Jones as brokerage firms restrict sales of leveraged and inverse ETF products.
  • 8/28/2009: Barclays Global Investors (NYSEMKT:BGI), owner of the largest family of ETFs, iShares, announces it will no longer create new shares in its iShares S&P GSCI Commodity-Indexed Trust (NYSEARCA:GSG), citing troubles
  • 9/1/09: Finra expands margin requirements for accounts holding leveraged and/or inverse ETF products to be enacted December 1, 2009.  Finra spokesman explains, “[Investors] are buying a leveraged ETF, then taking on additional leverage through a margin account. We felt it needed to be addressed.”  Margin requirements were previously set at 25% and are set to double for 2x funds and triple for 3x funds, yet won’t meet 100% of the security’s market value.
  • 9/3/09: A variety of class action lawsuits launched against ETF fund family, Proshares, and its Ultra Short products, ETFs including the UltraShort Oil and Gas (NYSEARCA:DUG) and Ultra Oil and Gas Funds (NYSEARCA:DIG), as well as the UltraShort Financials (NYSEARCA:SKF) and Ultra Financials (NYSEARCA:UYG), in which investors have suffered substantial losses.
  • 9/4/2009: Invesco’s PowerShares DB Crude Oil Double Long Exchange Traded Note (DXO) announces that it will redeem all outstanding shares of the ETN.

What’s happening

premiumUNG

Premium/Discount for UNG from ETFConnect.com

In the wake of all this, many inverse and leveraged funds have stopped issuing new shares. Consequently, many of these funds have begun to trade a huge premiums over NAV as investors, aware or unaware of what is underway, continue to bid them up.  One fund, the DXO referenced above, is closing completely and retuning money to investors amidst rising inability to effectively track their index.

See what’s happening to one of the most popular commodity ETFs, the United States Natural Gas Fund (NYSEARCA:UNG).  It’s premium over NAV has exploded in September.

What’s affected

Advisers need to be aware of what’s occurring in this environment and adjust accordingly.  Everything is game right now: commodity ETFs, leveraged ETFs and inverse ETFs.  Here’s a short summary of some of the fund families and tickers that may be affected:

Commodity ETFs: See SeekingAlpha’s list of commodity ETFs and ETNs to determine if you or your clients own any of these products.

Leveraged ETFs: Ditto on the leveraged market cap ETFs, leveraged growth/value ETFs, and leveraged sector ETFs.

Inverse ETFs: Look into inverse market cap ETFs, inverse growth/value ETFs and inverse sector ETFs.

Going forward:

Expect some more fund closures and weird skewing of security prices away from NAV.  More brokerage firms will make it harder to sell and buy these securities either directly or through an adviser.  Don’t expect the ETF industry to roll over and go away, though.  A lot of money and time has been committed to these products and a lot more innovative products are in the registration pipeline.  One way that ETFs may escape scrutiny, at least for those that use futures for leverage, is to switch from a daily tracking strategy to a monthly one.  The daily strategy has proven a disaster in most cases as a structural tracking error erodes returns no matter where the underlying assets trade.  Again, outside of the structural flaws of using a daily tracking strategy, these securities are not necessarily the problem.  They’re useful for a lot of things like easy, cheap ways of shorting and leveraging up without requiring clients to sign options papers.  Regulators are throwing everything they’ve got as these securities have become the whipping boys of 2008 investor losses.  Everyone just needs to make sure buyers understand how they work and how leverage affects potential losses.