Articles Posted in Leveraged & Inverse ETFs

Thumbnail image for Thumbnail image for money_trap.jpgAuthor: Joanna LiCalsi (Law Student, Investor Justice Clinic, University of San Francisco School of Law)

In June 2009, the Financial Industry Regulatory Authority (FINRA) responded to the explosion in popularity of leveraged and inverse mutual funds and exchange traded funds (ETFs) and the detrimental losses they’ve caused to many confused investors, by issuing a Regulatory Notice to brokers and firms. The telling notice says that these funds are “typically unsuitable for retail investors,” and then proceeds to remind brokers of their duties and obligations to customers regarding ethical sales practices and recommendation suitability. Generally, a concern over a lack of risk disclosure and mitigation were at the heart of the alert. FINRA even reminds firms that close broker supervision is necessary to ensure that this warning is heeded. Two months later, the SEC and FINRA released a joint Investor Alert (only the second time they’ve done that) about leveraged and inverse ETFs and the confusion pervasive amongst investors. The alert focuses on the high risk and extreme short-term nature of these funds. Essentially, they’re telling investors to avoid them like the plague.

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Thumbnail image for Thumbnail image for Thumbnail image for money_trap.jpgAuthor: Joanna LiCalsi (Law Student, Investor Justice Clinic, University of San Francisco School of Law)

To begin with, a very basic understanding of what leveraged mutual funds and exchange traded funds (ETFs) are and how they work is crucial to understanding their extreme risk. First, an issuer decides which index to track – this could be broad like the S&P 500 or more specific, like commodities or currencies. The goal is to outperform the indexes by doubling, and even tripling returns (depending on the fund – some names include “2x” and “3x” to denote the specific goal). Marketed as complex and sophisticated instruments for the common investor, leveraged ETFs are attempting to magnify daily market moves through the use of a massive amount of leverage (aka debt) and a strategy, which includes short sales, swaps, derivatives, options, and futures (many compare the strategy to trading on margin). Inverse ETFs work the same way, but in reverse, by betting on down-markets in an attempt to get multiplied inverse returns. Using leverage magnifies gains, but don’t forget – losses are magnified too!

In order to achieve the phenomenal, promised returns for leveraged ETFs, managers must vigilantly watch over the funds, maintaining equal proportions of debt and equity at all times. For example, if the market drops, a manager will need to sell many shares in order to reduce the debt level and hold the necessary ratio. This applies to a bull market in reverse (ie. if the market goes up, shares must be bought to get back to the correct amount of leverage). This incredible amount of turnover through constant buying and selling increases exposure to the market, and therefore, volatility.

money_trap.jpgAuthor: Joanna LiCalsi (Law Student, Investor Justice Clinic, University of San Francisco School of Law)

Just like everyone else, investors may find themselves caught up in trends – especially when it looks like a lot of money can be made relatively easily. Leveraged and inverse mutual funds and exchange-traded funds (ETFs) are such trends, both developed and exploding in popularity only over the past few years. Some big name fund companies in this line of investments are Rydex, ProShares (sometimes traded as ProFunds), Direxion, and SGI. They are sold as either ETFs or mutual funds with promising names, which usually include words like “growth,” “income,” and “preferred.” And, as is the case with leveraged ETFs, these funds assure investors that not only will they outperform any given index, but their returns will be double or triple that of the underlying index.

Inverse ETFs are just what the name implies – they seek to deliver the inverse (or opposite) of the tracked index. This is basically betting against the market and on declines. All of this sound great, right?!?! That’s exactly why so many investors (and retirement funds) have fallen victim to them.