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FINRA is Right: Leveraged ETFs are Dangerous to Your Financial Health

Chalk one up for the Financial Industry Regulatory Authority (FINRA). The brokerage industry's much-maligned self-regulatory agency has, like most financial regulators, taken a lot of heat in the wake of the current market meltdown, but they got one right with their regulatory notice last month on leveraged exchange-traded funds (ETFs).

In the notice, FINRA warned brokers and advisers of the duty they owe their clients to recommend only suitable investments, and said that a recommendation to hold leveraged and inverse ETFs for longer than one trading day was typically "unsuitable for retail investors." (A few different articles about the notice said that FINRA spoke of a fiduciary duty brokers owe their clients. This is incorrect. Brokers are not held to such a standard, unfortunately, and the notice made no mention of it.)

Leveraged and inverse ETFs are a relatively new entry in the ETF field. These funds are designed to provide double or triple an index's daily return, or double or triple its inverse return. A "double bear" fund, for instance, is supposed to increase two percent on a day when the index it tracks falls one percent.

The problem with them, which FINRA is rightly concerned about, is that over longer periods of time, their performance often has nothing to do the long-term performance of the index they track. A glance at the accompanying chart tells the story nicely. It plots the year-to-date performance of three ETFs: Direxion Daily Large-Cap Bull 3x, which is designed to triple the Russell 1000 Index's return; Direxion Daily Large-Cap Bear 3x, which triples the Russell 1000's inverse return; and the iShares Russell 1000 ETF, which (quaintly and simply) tracks the Russell Index.
As you can see, the iShares Russell 1000 ETF is essentially flat year-to-date, a fact that would lead most logical investors to expect the leveraged ETFs to be roughly three-times over and below that mark. Far from it. Instead, both are off more than 25 percent for the year. (None of the returns depicted include dividends.)

The reason for this apparent discrepancy lies in the impact of compounding. Assume that you invest $100 in a traditional index fund, and $100 in an ETF designed to double the index's return. On first day, the index increases 10 percent, thus you have $110 in the traditional fund, and $120 in the leveraged fund. The next day, however, the index plunges 20 percent. Your traditional fund falls to $88, and the leveraged fund falls to $72. On the third day, the market rises 15 percent. Now, your traditional fund is up to $101, while the leveraged fund's value is only $94. Thus you can see how, over the course of just a few months, the return you earn on one of these funds may have very little relation to the return of its underlying index.

Considered in that light, FINRA's admonition that these funds are not suitable for holding periods of more than a day makes perfect sense. Perfect sense for investors, of course. The providers of these ETFs were, as you might imagine, less than thrilled.

In a Reuters article, ProFunds chief executive Michael Sapir said "for unsophisticated investors, these are not products ... they should be using. Don't buy it unless you understand it." Hmmm. He makes them sound like they're, well, sophisticated investments, right? That's a markedly different tone than he struck when his firm launched their first leveraged inverse ETFs three years ago, when he told Investor's Business Daily that "what the Short ProShares does is it makes shorting a part of the market simple and easy. You can short a part of the market like just buying a stock, which most people understand how to do."
Indeed, most people do understand how to buy a stock. Being skilled enough at it to buy one that outperforms over time is a different matter altogether. And being skilled enough to profitably time your purchases and sales of a leveraged ETF, well, that's an expectation that borders on ridiculous, no matter how sophisticated you fancy yourself.

The fact of the matter is that these instruments have no place in 99.9 percent of all investors' portfolios. That they make it so "simple and easy" for an investor to play their hunch on which direction the market is headed only serves to understate the damage these investments will likely do to their portfolio. Using them is the functional equivalent of letting your crazy uncle set off Zambelli Brothers fireworks at your neighborhood barbeque -- he's far more likely to blow something up than he is to provide entertainment.

So three cheers for FINRA for getting this one right. Let's hope they have the courage to withstand the "discussions" Sapir and company will be having with them over this issue in the coming weeks.