More Laughable Leveraged ETF Lawsuits

by on January 21, 2010 | ETFs Mentioned:

One of the major stories in the ETF industry over the last year has centered on the appropriate uses and potential abuses of leveraged ETFs. In the wake of the unprecedented equity market volatility during 2008 and the first quarter, some investors expressed dismay over the performance of 2x and 3x leveraged funds over multiple trading sessions. While these investors account for a very small portion of leveraged ETF use, their outrage caused quite a stir, and even sparked several lawsuits.

Because leveraged funds are designed to deliver amplified returns on a benchmark on a daily basis, their exposure is reset daily. Consequently, returns to these funds over multiple trading sessions depend on both the change in the underlying index and the path of the benchmark during the period in question. In trending markets, the return on a leveraged ETF often exceeds the simple product of the target multiple and change in the benchmark. In seesawing markets, the compounding effect can lead to results that are less than daily target multiple times the index movement. In certain environments, a leveraged bull fund may deliver negative returns over an extended period even if the underlying index advances.

Wilfred leaving the court houseOver the last month, the law firm of Stull, Stull & Brody has been churning out class action lawsuits against leveraged ETF issuers, alleging that wrongdoing in the promotion of these products. While the firm may make a splash and grab a few headlines, the lawsuits lack any substantive claims, and border on downright embarrassing to those behind them. The prospectuses for leveraged clearly spell out that the objectives of the funds are daily in scope. Beyond the official documents from the issuer, the quantity of publicly-available information covering these topics is astounding. It’s unfortunate that some investors failed to comprehend how leveraged ETFs work and incurred losses as a result, but the logic behind assigning the blame to the issuers of the funds seems flawed.

Beyond the basic premise of the lawsuits–that leveraged ETFs were sold as instruments that would deliver amplified results regardless of holding period–there are a number of curious accusations. The press release announcing an investigation into the ProShares Ultra Basic Materials (UYM) notes that the law firm is investigating claims that ProShares “failed to disclose in its registration statements: (i) that if shares of the Funds were held for a time period longer than one day, the likelihood of massive losses was huge; and (ii) the extent to which performance of the Funds would invariably diverge from the performance of the benchmark.”

It’s tough to tell what exactly is meant by “the likelihood of massive losses was huge,” but proving that notion to be false should be relatively simple. A number of studies have shown that leveraged ETFs, while not designed to do so, have historically done a pretty good job of delivering leveraged results over multiple sessions (one such study was recently published here).

Another interesting allegation comes from a press release announcing that the same firm was investigating the Direxion Energy Bear 3x Shares Fund (ERY). The firm notes that the Russell 1000 Energy Index fell approximately 11% between November 5, 2008 and April 9, 2009 while the 3x bear Direxion fund linked to this benchmark fell approximately 54% over the same period. Besides conveniently using the wrong name for the fund–it’s actually the Direxion Daily Energy Bear 3x Shares–and erroneously computing the return on the Russell Energy Index over the time period in question, the release notes that:

Given the spectacular tracking error between the performance of the ERY Fund and its benchmark index, investors in the ERY Fund have been shocked to learn that their supposedly correct play on the energy sector has caused them substantial losses. The fact that Plaintiff and the Class sought to protect their assets by investing their monies on the correct directional play has been rendered meaningless. The ERY Fund is, therefore, the equivalent of a defective product. The ERY Fund did not do what it was designed to do, represented to do, or advertised to do.

This accusation seems like a slam dunk to defend as well. It’s made pretty clear that ERY operates with a daily objective, seeking to deliver daily investment results corresponding to 300% of the inverse of the daily change in the Russell 1000 Energy Index. Over the time period in question (and since then), ERY did a very good job of accomplishing its stated objective. The fund delivered daily returns between -250% and -350% of the daily change in the Russell 1000 Energy Index more than 70% of the time. If the range is expanded to -200% to -400%, the success rate jumps above 85%. These clearly aren’t results typical of a “defective product.”

ETFdb Pro members can read more about the underpinnings of leveraged ETFs in the ETFdb Category Report (if you’re not a Pro member yet, sign up for a free trial or read more here).

What’s Next?

The ETF industry has gathered tremendous momentum over the last two years, attracting hundreds of billions of dollars from mutual funds and expanding the scope of product offerings to cover almost every corner of the investable universe. The wave of lawsuits will likely be little more than a speed bump along the way.

But it is a threat to the industry’s growth. Given the seemingly frivolous nature of the recent suits, it wouldn’t be surprising if other issuers and products are soon targeted. Why not take aim at commodity products? The United States Natural Gas Fund (UNG) may do exactly what its prospectus says it will, but many investors expect the fund to track movements in spot prices, and it doesn’t. Or how about the iShares Emerging Markets Index Fund (EEM)? The strategies used are clearly outlined in registration materials, but the fund trailed its benchmark by about 7% in 2009 due primarily to sampling strategies.

Of course, such suits would be without much merit. But that clearly hasn’t been much of a deterrent in the past.

Disclosure: No positions at time of writing.