FINRA Zeroes In On Leveraged ETFs

by on July 3, 2009 | ETFs Mentioned:

The Financial Industry Regulatory Authority (FINRA) has completed an initial information sweep of U.S. firms that sell leveraged ETFs, seeking to gather information about sales of these products to investors with accounts of less than $10 million. Leveraged funds, which seek to amplify daily returns on a benchmark equity or bond index by using leverage, have been the topic of much debate lately in the ETF industry. While the securities are well-suited for investors such as hedge funds and day traders, numerous parties have expressed concern that they could be used improperly by a less sophisticated breed of investor. Due to the compounding of returns, the performance of leveraged ETFs over extended periods of time can vary in both magnitude and direction from the return on the underlying index, an understanding that may elude “average” investors.

Leveraged ETFs have become extremely popular over the last year, with countless new funds being launched. After ProShares pioneered the product offering with a line of 2x leveraged funds, Direxion upped the ante by developing an extensive line of 3x leveraged ETFs. Direxion’s 3x Bull (FAS) and 3x Bear (FAZ) Financial Sector ETFs are two of the most-traded ETFs on the market today, behind only SPY and XLF in three-month average volume. Despite their popularity, and efficiency in achieving their stated objectives, leveraged ETFs have a number of opponents who believe they are fundamentally dishonest products. Vanguard founder Jack Bogle recently stated the these funds “verge on insanity.” But many of these detractors have relied primarily on hypothetical or anecdotal evidence to support their criticisms, largely because good empirical data detailing the use of these funds hasn’t been made available. After numerous calls for the compilation of some statistical support, it looks like FINRA is stepping up to finally compile some statistics that will quantify the scope and severity of the “problem” posed by these funds.

ProShares Responds

On June 11, FINRA issued Regulatory Notice 09-31 to remind brokers that any security they offer, including leveraged ETFs, must be suitable for their client. “We actually support the FINRA notice, except for one piece of it, we’re very supportive of the effort to educate,” Michael Sapir, chairman and chief executive of ProFunds said. “For unsophisticated investors, these are not products…they should be using,” Sapir said. “Don’t buy it unless you understand it.” ProShares disputes the notion that leveraged ETFs are one-day only investments, and the issuer is currently developing an education program for both retail investors and brokers.

Where Do We Go From Here?

Although FINRA concluded its information sweep several weeks ago, the industry watchdog is still analyzing the data. Spokesman Herb Perone indicated that “the marketing and sale of these products to unsophisticated retail investors is very much on FINRA’s radar screen.” It’s my hope that FINRA will be willing to share the data it is compiling at some point, in order to give the industry a better idea of exactly who is using leveraged ETFs and how they are using them.

I’ve been adamant in my defense of the leveraged ETF issuers, lauding them for presenting thorough and easy-to-understand educational material on the financial mechanisms utilized by these funds and the risks that they entail. I’ve also been skeptical of the extent of “abusive use” of these funds given the lack of any hard data to support such notions. Now it looks like I’m finally going to get my wish, some cold hard stats to better frame the issue and allow for more constructive discussions about how to resolve this hot-button issue.

View fact sheets for ETFs mentioned in this article: FAS, FAZ, SPY, XLF.

Disclosure: No positions at time of writing.