Business | Investment
Heat on leveraged and inverse exchange traded funds
Though there is still demand for the products, flows have been declining in recent months.
- By Luisa Beltran, Financial Times
- Published: 22:16 September 18, 2009
Leveraged and inverse exchange-traded funds have been facing a lot of regulatory heat lately, but the products and the companies that provide them are expected to withstand the scrutiny.
The summer saw several companies - including UBS, Ameriprise, Edward Jones, Morgan Stanley, Wells Fargo Advisors and LPL Financial - impose restrictions on leveraged and inverse ETFs.
Anxiety over the products reached fever pitch in August when the Securities and Exchange Commission issued a joint warning with the Financial Industry Regulatory Authority. The warnings came after it was reported that Massachusetts authorities, led by Secretary of the Commonwealth William Galvin, were investigating the sales practices of companies that offer the funds. The regulators were concerned, they said, that retail investors were confused about the ETFs.
"The important thing for investors to understand is that [leveraged and inverse ETFs] reset on a daily basis," says John Gannon, Finra senior vice-president for investor education. "If they hold them for longer than a day, they are unlikely to see the return they expected."
He gave an example of a leveraged ETF that tracks the S&P 500. Some investors believe that if the S&P 500 is up 10 per cent for the year, the leveraged ETF will return 20 per cent. "That is not the case," says Gannon. "These funds only double the daily return."
It was this confusion that prompted iShares to decide against offering leveraged and inverse ETFs in 2007, says Mike Latham, co-chief executive. "We concluded that the way the products would be structured wouldn't deliver to clients what they expect," he says.
Still, ProShares, which launched the first leveraged ETF in June 2006, has been "wildly successful", Latham admits. ProShares is the biggest provider of leveraged and short ETFs, with $27 billion (Dh99 billion) in assets under management. The Bethesda, Maryland-based firm in August introduced its 90th fund.
By comparison, Direxion Funds, its smaller competitor in the leveraged and inverse ETF space, has 22 "bull and bear" funds and $6.5 billion in assets. Rydex/SGI has 14 funds that account for $336 million in assets.
Michael Sapir, chairman and chief executive of ProShares, believes the problem with leveraged and inverse ETFs is simple. It is the maths. Investors misunderstand the effect of compounding. "The funds are designed to meet their objective on a daily basis," Sapir says. "They've done an excellent job."
Leveraged ETFs use futures or derivatives to provide a multiple of an underlying benchmark index, while a leveraged inverse fund seeks a multiple return that is the opposite of the benchmark index. The funds keep levering up as the underlying investment performs well while reducing their exposure as the investment goes down, says Bradley Kay, a Morningstar ETF analyst. "But once a fund incurs a large loss it is almost impossible for it to make up the lost ground," he says.
No one disputes the popularity of leveraged and inverse ETFs, despite the condemnation of the funds. Of the 767 ETFs trading in the US, 127 are leveraged and/or inverse, according to Morningstar. The funds have seen nearly $9 billion in flows this year on a net basis while daily trading volumes average "hundreds of millions of shares each day", Sapir says. "This tells us that the [funds] are viewed by many as a useful part of portfolios for certain investment strategies."
Dan O'Neill, Direxion Funds' president and chief investment officer, agrees with regulators that the products should not be used by long-term buy and hold investors. He defines the proper user as someone who frequently looks at their portfolio and makes adjustments. "The funds are sold properly as short-term, tactical products. We do all we can to convey that message."
O'Neill disagrees with Finra's claim that leveraged and inverse ETFs may not be suitable to hold for longer than a day. "There is no correct holding period."
Finra was disturbed by a study from State Street Global Advisors, according to Gannon. In a mid-year review of ETFs, SSgA found that the top three leveraged and inverse funds - all offered by ProShares - were mainly held by retail investors. Institutional ownership was limited. "This just posits the question of whether retail investors truly understand how these products work," Gannon says. "And, no they don't." Massachusetts regulators have been closely monitoring the products and are investigating how they are sold to investors.
"We are not saying the products are intrinsically bad," says Galvin. "But they are not something that every prospective investor would be advised to have."
The Massachusetts regulator has yet to decide whether its investigation will result in any action or an administrative complaint. "Our concern is the products' suitability for the mass investors." Investors have complained to Finra and Galvin about the funds. Finra, which regulates the practices of 4,900 brokerage firms, is finishing its information gathering. This could result in a range of regulatory measures.
In spite of the restrictions imposed on leveraged and inverse ETFs, few doubt the funds will continue to be offered. Scott Burns, Morningstar's director of ETF analysis, believes regulators will probably impose stricter qualification requirements for leveraged and inverse ETFs.
Though there is still demand for the products, flows have been declining. In July, leveraged ETFs and exchange traded notes saw outflows of $1.85 billion while the ETF industry drew in roughly $9 billion overall, according to data from Morningstar. Assets have also dropped recently, from $29.6 billion in July to $28 billion as of August 25.
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