How To Fix the Leveraged ETF Mess

by on June 26, 2009 | Updated August 12, 2009 | ETFs Mentioned:

Leveraged ETFs have quickly become the hot-button issue in the ETF industry, dividing investors and observers into two distinct camps. On the one side are sophisticated day traders who believe these funds, which use derivatives and other complex financial instruments to provide amplified daily returns on a target index, are the greatest thing since sliced bread. And on the other are those who accuse these ETFs of being fundamentally dishonest in nature – products that, in the words of legendary investor Jack Bogle, “verge on insanity.” Personally, I fall somewhere in between, believing that leveraged ETFs can be an incredibly powerful tool for sophisticated investors, but acknowledging that there exists the potential for these funds to be used in a detrimental manner by investors unaware of exactly how they function. And while I’m generally inclined to let things be, it’s becoming increasingly clear that this issue will not be going away any time soon unless we address a few key issues.

Houston, Do We Have a Problem?

My biggest frustration with the camp that believes leveraged ETFs are fundamentally dishonest products that are harming scores of investors is the lack of any empirical data. All the arguments that I’ve read against leveraged ETFs are based on anecdotal evidence or, even worse, “hypothetical evidence” – tales of how investors could possibly be defrauded. I understand that there is potential for misuse, but I am not convinced that such abuses are actually occurring. So before we set out to “fix” the issue of leveraged ETFs, we need to understand just how big of a dragon we’re trying to slay. What I’d like to see is data from asset managers and online brokerages detailing the number and percentage of accounts that have held leveraged ETF products for various periods of time (i.e., more than one day, more than five days, more than a month, etc.). This should tell us exactly what we’re dealing with, and give regulators an idea of how far they should go in their efforts to address the problem.

In the absence of this data, I took a look at the implied turnover for the 20 largest leveraged ETFs (by market capitalization). As presented below, 16 of these 20 funds have an average daily volume less than their total shares outstanding, implying that at least some of these funds are being held for multiple trading sessions.

These Statistics Paint a Troubling Picture

A Tale of Two Solutions

For the time being, I’ll assume that the data indicates that leveraged ETFs are indeed being used inappropriately. In my mind there are actually two separate problems here: (1) “average Joe” investors buying-and-holding leveraged funds through their online brokers, and (2) professional money managers adding leveraged ETFs as a long-term holding for client accounts.

Let’s start with the first group. Some will no doubt accuse me of being callous, but I don’t see this as much of a problem. The amount of literature available on leveraged ETFs is astounding. Anyone who has done even a cursory amount of research will be inundated with warnings about the very narrow intended audience for these funds. (If you don’t believe me, spend five minutes doing a few Google searches.) Moreover, as I’ve said before, the issuers of leveraged ETFs (primarily ProShares and Direxion in the U.S., and ETF Securities in Europe) should be applauded for their efforts to educate potential shareholders and steer less sophisticated investors elsewhere. In addition to the standard disclosures required in the prospectus, the web sites of these issuers prominently feature education centers and easy-to-understand examples detailing the risks associated with the compounding of returns.

If investors are plunging their hard-earned dollars into these funds for extended periods of time despite the abundance of stern warnings, further regulation is not going to be effective. As Morningstar’s Scott Burns notes, in any trading or brokerage account, investors must get approval to trade options or derivatives by reading (or claiming that they read) a 216-page overview. He’s in favor of applying similar requirements for leveraged ETF investors.

So let me get this straight. An investor has been misinformed (or underinformed) about the mechanics of leveraged ETFs, decides they are a way to get rich quick without doing even a minimal amount of research, and attempts to purchase funds through his broker. Now having to check a box indicating he’s read an encyclopedia on the risks of leveraged ETFs is going to cause him to reconsider? Pardon my skepticism, but making investors jump through a few additional hoops will only waste more money.

Moreover, the business of protecting investors from themselves is a slippery slope. Why not implement regulations that prevent aging investors from investing heavily in emerging markets ETFs? Or dissuade them from investing heavily in a single security? What about warning them that currency funds aren’t expected to return anything over the long term? At a certain point, we have to draw a line: provide investors with sufficient information to make an informed decision, and let them make their own decisions. As the old saying goes, a fool and his money are soon parted.

The Real Problem

While I’m admittedly unsympathetic towards investors who invest their own funds in leveraged ETFs without doing their homework, I feel for anyone who has suffered monetary losses due to the ignorance of a professional money manager they trusted with their future. If financial advisers are indeed subjecting the portfolios of unsuspecting clients to undesired risk factors by holding leveraged ETFs for extended periods of time, we’ve got a major problem on our hands. These professionals theoretically have a fiduciary duty to their clients. If they are indeed implementing buy-and-hold strategies on leveraged funds, this duty has been breached in a serious way, apparently without so much as raising a red flag or triggering an internal review. If this is the case, going after the sponsors of these funds is like blaming Ray Kroc for your weight problem.

Being reckless with your own money is foolish, but doing so with someone else’s borders on criminal. For individuals who have breached their duties to clients by holding leveraged ETFs for an extended period, the punishments (already specified by the various sets of ethical codes and standards by which the industry is bound) should be carried out swiftly. Loss or suspension of license would not be overly severe for such transgressions.

Although some seem to think otherwise, I find it hard to believe that asset managers are putting client dollars into leveraged ETFs with any malicious intent. There is, quite simply, no financial incentive for them to do so. These (alleged) actions are born out of ignorance. Granted it is an inexcusable ignorance, but certainly not premeditated malice. The best solution to such ignorance is education.

The solution is a two-part one. First, let’s make asset managers either attend a continuing education session or complete a self-study program on the functions and risks of leveraged ETFs. The concepts behind leveraged ETFs are easy to understand when explained by a knowledgeable individual, so coverage doesn’t have to be prohibitively expensive or time consuming. To make sure the information is getting through, and that managers aren’t simply “checking a box” let’s subject them to a brief but challenging standardized test before they’re allowed to buy and sell leveraged ETFs on behalf of clients. I know this might seem obvious (and it can no doubt be expanded upon), but it would go a long way towards resolving the issue.

Second, the organizations responsible for the issuance of financial designations and certifications (CFP, CFA, etc.) need to work the issue of leveraged ETFs into their curricula. The fury over leveraged ETFs, while red hot at present, will inevitably die down. But the potential for abuse will remain. Awareness of these instruments and education on when they are and are not appropriate must become a key component of the certification process in order to ensure that we’re not having this debate over and over for the next 20 years.

Walking The Line

The solution to the leveraged ETF problem (if indeed there is one) must walk a delicate line by allowing sophisticated investors to continue to utilize efficient and effective trading vehicles and protecting investors who are vulnerable to abuses from dangerously ignorant professional managers with whom they trust their investments. It’s a tricky issue that is going to require cooperation and compromises from a number of parties. And while the problems posed to the ETF industry by leveraged funds are no doubt nebulous and complex, it’s about time we begin crafting a solution.

Disclosure: No positions at time of writing.