Canadian Regulators Respond to Leveraged ETFs

by on June 18, 2009 | ETFs Mentioned:

It’s good to know that we’re not alone. It seems our neighbors to the north are struggling with the issue of leveraged ETFs as well. Last week, the Investment Industry Regulatory Organization of Canada (IIROC) issued recommendations aimed at eliminating inappropriate use of these funds by investors unaware of their risk profiles and the manner in which they seek to generate their amplified returns. While the announcement indicated their concern regarding the issue, it’s unlikely to have any significant impact, and further underscores the difficulties these securities are posing to regulatory agencies.

Leveraged ETFs, which seek to amplify the daily return on a benchmark index by a predetermined percentage (usually 200% or 300%) have been the subject of heated discussions in investment community lately. These ETFs are popular among day traders who use them to double or triple down on their predictions on short-term market movements. Winning bets can mean a big payday, but losing bets made with these funds result in much bigger losses. The concern isn’t about sophisticated investors using these funds however. It’s with average investors who buy leveraged ETFs and hold them for extended periods of time, mistakenly believing that their investment will return a multiple of the return on the underlying index.

In reality, however, due to the compounding of returns, the percentage change in the prices of these leveraged ETFs can vary in magnitude (and even direction!) from their underlying index. There’s a rather complex explanation, but this phenomenon is perhaps best demonstrated by an example: while IWB, which tracks the Russell 1000, is up 3.1% on the year, BGU, a 3x Direxion fund based on the same index, is actually down 7.2% (and not up 9.3% as some would expect).

FAIR Warning

In May, the Foundation for Advancement of Investor Rights (FAIR), a shareholder advocacy group, expressed concerns that retail investors may not understand the risks of leveraged ETFs, and may be placing their money in assets that maintain inappropriate risk characteristics. In response, the IIROC issued a statement reminding dealers of their obligations to sell in a clear and fair manner that protects investors. Firms that sell leveraged ETFs must have procedures indicating that a customer-specific suitability analysis has been performed and must have adequate supervisory procedures in place to monitor and control these sales practices.

Not Very Effective, Eh?

While the IIROC’s actions placated FAIR’s founder, it seems to me like little more than idle rhetoric that won’t result in any major changes. Besides being incredibly vague, the agency’s recommendations don’t go beyond any standards already in place. The IIROC regulates investment advisors who manage client funds. If the managers regulated by this agency aren’t already conducting suitability analyses (at least informally) when making investment decisions for their clients, we’ve got a major problem on our hands – renegade asset managers allocating client funds without regard for their risk tolerance or return objectives. The whole asset management business (not to mention the code of ethics related thereto) is premised upon selecting suitable investment products on behalf of clients. So IIROC’s recommendation changes things…how?

Maybe there’s more to this “warning” to come, but for now it seems to me like the IIROC’s latest pronouncement will do little to resolve a problem that many regulators in North America are struggling to understand and address in a practical manner.