The swelling controversy over the risks associated with leveraged ETFs has apparently caused its first casualty. St. Louis-based Edward Jones & Co., the prominent financial services firm, decided during a regular review of its products in June to stop selling leveraged funds, citing the fact that they are “one of the most misunderstood and potentially dangerous types of ETFs,” according to mutual fund research analyst Katie Martin. Edward Jones prepared a report titled “Not All ETFs Are Created Equal” that highlights the potential pitfalls with these complex financial instruments.
“Investors also need to recognize that leveraged ETFs have an increased potential for capital gains distributions and significantly higher expense ratios than the traditionally broadly based stock market ETFs, negating some of the benefits of purchasing an ETF,” the report said. Edward Jones’ decision to drop the product line comes as calls for regulation of leveraged ETFs are reaching a fever pitch. In recent months, a number of industry analysts (including Scott Burns of Morningstar) have called for increased oversight, joining individual investors frustrated by the returns generated by these funds over extended holding periods (due to compounding of returns and daily resets, leveraged ETFs can vary in magnitude and even direction from the amplified return on the underlying index if held for multiple trading sessions).
More recently, FINRA reminded brokers and RIAs to use caution in selling leveraged funds, ensuring that they are suitable investments for their clients. After conducting a data sweep in an attempt to quantify the issue, FINRA backpedaled a bit on its position, noting that “leveraged and inverse ETFs can be appropriate if recommended as part of a sophisticated trading strategy that will be closely monitored by a financial professional.” And just last week, Massachusetts Secretary of State William Galvin announced that his office in examining sales practices of Direxion, ProShares, and Rydex.
Wild Ride Continues
The debate over leveraged ETFs, which has divided the investment community into those who love their inherent risk and those who view them as fundamentally dishonest products, has now taken a few more bizarre turns. Just as the industry’s independent regulator eased off its investigation (perhaps because of calls to do so by the Investment Company Institute), an ambitions secretary of state is poised to sink his teeth in, and one of the country’s largest asset managers has distanced itself altogether. The move by Edward Jones seems surprising, especially given the tremendous popularity of leveraged ETFs. In the past few months, a number of new leveraged ETFs have hit the market (or filings have made their way to the SEC), as demand for these products remains high among the most sophisticated and risk-seeking investors:
- FactorETFs recently filed to launch a new line of ETFs that offer a unique spin on the traditional concept of leverage. The proposed funds would seek to amplify daily excess returns delivered by one asset class of sector relative to another (or relative to the broad equity markets).
- Direxion launched a pair of 3x leveraged real estate funds based on the MSCI U.S. REIT Index last week, the first funds to offer 300% exposure to REITs (ProShares currently offers a duo of 200% leveraged real estate funds – SRS and URE).
- MacroShares, best known for its $100 Oil Up/Down funds, returned to the ETF scene with a pair of exchange-traded products (UMM and DMM) offering leveraged exposure to the U.S. housing market.
- ProShares recently launched two new UltraShort ETFs – EPV and BZQ – that offer 200% leveraged inverse daily exposure to Europe and Brazil, respectively. Along with these funds, ProShares also introduced two inverse international ETFs: JPX (Pacific ex-Japan) and SMK (Mexico).
- In early June, ProShares introduced four new leveraged international ETFs, including EFO (EAFE), EET (emerging markets), XPP (China), and EZJ (Japan).
Disclosure: No positions at time of writing.