Leveraged ETFs: Separating Myths From Facts

Leveraged exchange traded funds (ETFs) have seen a lot of popularity and garnered a lot of attention with the recent market decline.

These ETFs have the ability to be two to three times long or short the market; all wrapped up in a single tradeable security.

Some pundits believe these specialized ETFs have, in fact, increased market volatility in the last hour of trading. But many investors and people in the media are having trouble getting their arms around the truth. The SEC has been looking very closely at these funds and have had dialogue and visits with ETF providers who are offering them. Here are the facts:

Complaint: Leveraged ETFs Are Too Readily Available and the Average Investor Will Hurt Themselves

Fact: What’s wrong with choices? We’re all adults here. Investors deserve to have options, and the more, the better. Give investors some credit. I know our readers on ETF Trends, and they’re a smart, educated, affluent bunch. It’s up to you and I to get the necessary education so we don’t shoot ourselves in the foot.

Furthermore, the fund companies that issue leveraged ETFs readily admit that their funds aren’t for everyone. They’re very open about the risks. As much as the fund companies want to make money, they also want their investors to be successful, too. It behooves them to help investors do that. As Jason Zweig of The Wall Street Journal noted in his Saturday column, it’s all about understanding risk and knowing what you’re getting into with these funds.

Another point to consider is that it’s hard to know exactly who’s buying these funds, but based on the volume being traded, it would suggest that it’s largely institutional. It’s true that anyone can buy them, but the big players are likely the ones buying them at this point, so their accessibility is probably moot for now.

Complaint: They Exist So Investors Can Sidestep Margins Rules

Fact: It’s really not that sinister. Before leveraged ETFs, investors had to borrow from a broker to short with credit, then have a required amount of reserve capital before doing so. These limitations don’t exist with leveraged ETFs, but I doubt that most investors are arching their eyebrows and laughing wickedly at the thought of sidestepping margins rules.

The less exciting truth is that these funds have simply made it easier for the average investor to employ a strategy he or she might not have had access to before. Additionally, margin rules were set up to protect banks, not investors, so this argument doesn’t hold much water. Investors can only lose what they put into these funds.

Complaint: Leveraged Funds Are Bringing the Market Down

Fact: There are a lot of things making it difficult for the government to save financials, and it isn’t right or fair to put the blame on the shoulders of leveraged ETFs. Trading and interest in them has undoubtedly increased, but billions of shares trade hands each day in funds of all types.

A small fraction of that is leveraged ETFs, and they seem to be getting a far greater percentage of the blame. One industry expert points out that if you look at the net assets in both the long and short funds, the levels are net long in the majority of the fund pairings most of the time. If anything, they’re having a positive effect on the market.

Complaint: They’re Not Buy-and-Hold Investments

Fact: Well, that is true. They’re not. But this isn’t exactly news - many leveraged ETF investors have been able to successfully hedge their portfolios for short-term periods. These ETF providers readily acknowledge that these types of funds are meant to hedge risk, not funds around which one should plan their retirement.

Complaint: Leveraged ETFs Just Don’t Work

Fact: Leveraged ETFs operate exactly as they should - they reset daily. Over a period of time, you’re going to see internal compounding that will affect the returns. This isn’t a flaw in the funds - this is a mathematical fact that is impossible to avoid. If you invested in a leveraged ETF over a period of months and the market went down 20%, a 2x short leveraged ETF wouldn’t go up exactly 40%.

The SEC is ultimately going to find that there’s nothing illegal or underhanded about these products. They’re doing what they’re supposed to do, they’ve proven immensely popular and the SEC would not impose limits or consider doing away with such innovative products.

Disclosure: Tom Lydon is a board member of Rydex Funds.

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