Changes Coming To Leveraged ETFs?

by on September 10, 2009 | ETFs Mentioned:

Direxion, the ETF sponsor responsible for many of the most heavily-traded ETFs on the market, is reportedly making some changes to its line of mutual funds that may ultimately impact the leveraged ETF industry.

Many investors have the misconception that leveraged ETFs are a new invention. While their packaging into an ETF structure is a relatively new concept, the underpinnings of these securities have been around in leveraged mutual funds for quite some time. In addition to its market-leading line of 3x leveraged and 3x inverse leveraged ETFs, Direxion offers several mutual fund products covering a variety of asset classes and geographic regions. The company’s leveraged mutual funds include seek to provide amplified daily exposure to a variety of benchmarks, including the S&P 500, NASDAQ 100, and Russell 2000, in much the same manner as their leveraged ETFs.

But now it seems that these leveraged mutual funds are going to get a facelift. Direxion has announced that it will change the timeframe of the mutual funds from daily to monthly, meaning that 2.5x bull funds will attempt to generate 250% of the monthly returns on underlying indexes. Instead of resetting daily, the funds would do so monthly. (It is important to note that this proposed change applies only to mutual funds, not to any of the company’s ETF products.)

The primary complaint (a misguided one) against leveraged ETFs has been impact of compounding returns on their long-term performance. Because of their daily time horizon, the returns of these products can vary in size and even magnitude from the return of underlying index multiplied by the target leverage. This issue is most severe in volatile, oscillating markets. FINRA summarized the issue in a recent release:

While such products may be useful in some sophisticated trading strategies, they are highly complex financial instruments that are typically designed to achieve their stated objectives on a daily basis. Due to the effects of compounding, their performance over longer periods of time can differ significantly from their stated daily objective. Therefore, inverse and leveraged ETFs that are reset daily typically are unsuitable for retail investors who plan to hold them for longer than one trading session, particularly in volatile markets.

Providing leverage on a monthly basis is nothing new to the ETF industry. Deutsche Bank and PowerShares have teamed up on a line of leveraged commodity products that seek to amplify monthly returns on price movements in commodities, including:

  • PowerShares DB Gold Double Long  ETN (DGP)
  • PowerShares DB Gold Double Short ETN (DGZ)
  • PowerShares DB Commodity Double Long ETN (DYY)
  • PowerShares DB Commodity Double Short ETN (DEE)

Some speculate that leveraged ETFs may adjust their model to track indexes over a longer time period. “One possible solution to the leveraged fund frustration would be to extend the tracking time frame of the underlying index,” writes Don Dion.” Since daily tracking funds are not suitable for average buy-and-hold investors, ETF issuers could create longer term contracts that seek to match returns on a monthly or even multi-month basis.”

While such a move might appease regulators and critics of these products, it would also chase off the most frequent users of leveraged ETF products, sophisticated day traders who move in and out of these funds at a frequency that would make most investors’ heads spin. What is more likely is not the evolution of existing funds but the introduction of an entirely new line of funds that provides leverage over a longer period of time. This is a variation of one of the ten ETF innovations we’d like to see hit the market, and now it appears it may not be that far off.

The leveraged ETF industry is at an interesting point now, constantly evolving and attempting to strike a balance between regulatory demands and investor preferences. To keep up to speed on all the developments in the industry, sign up for our Free ETF Newsletter.

Disclosure: No positions at time of writing.