Geared ETF Firms Deserve Help

September 19, 2012

Isn’t it time for regulators to step up and start requiring investors to take responsibility for their choices?

Last week a federal judge in New York dismissed a class-action lawsuit over leverage ETFs. I’d like to shake that judge’s hand, and let me tell you why.

Investors filed the lawsuit in August 2009, crying foul in connection with 44 leverage and inverse ETFs managed by ProShares Advisors LLC. The basic allegation in the suit was that ProShares didn’t disclose the risks of holding the ETFs for longer than a day.

The most striking part of the lawsuit was the allegation that ProShares knew in advance, through a “mathematical formula” that investors could suffer large losses. I’ll rarely take the side of an issuer over an investor, but in this case, I have no choice.

First, let me be clear, issuers should always disclose to investors the risks of their products. However, issuers can’t be responsible for the level of access to their products. That’s the core issue here.

For all the information out there about leverage and inverse ETFs, at the end of the day, it’s not voodoo. It’s really a matter of understanding volatility and compounding. That’s the most annoying aspect in all this.

People act as if issuers have this “magical mathematical formula” that somehow rips money out of investors’ hands and puts it into issuers’. It couldn’t be further from the truth.

The funds all promise to deliver the daily return of their underlying indexes, multiplied by the leverage factor—1X, 2X, 3X, etc. Depending on the degree to which the X-factor fluctuates, returns over the span of a few days can differ greatly from the daily leverage return, referred to as compounding.

In short, these products have done exactly what they were meant to do, which is provide daily exposure. However, investors assumed that that exposure would remain constant over time.

What I’m getting at is that the problem here isn’t with ProShares or any other inverse or leverage ETF issuer, but rather with investors taking responsibility for their investments.

Regulators' Role

Perhaps most important in all this is the role regulators should play in making sure that investors meet their responsibility.

If anything, the discussion should focus on what’s acceptable for retail investors to access in the ETF space. Earlier this year, our Director of Research Dave Nadig talked about the need to create an ETF Gate. I couldn’t agree more.

In a perfect world, all investors would read the fact sheets, statements of additional information and prospectuses before making investment decisions, but I’m not naive.

The fact is, no matter how much red ink you use, there’s a huge contingent of investors that won’t read the basic fact sheets, let alone the prospectus of a fund. Issuers have done a great job in using the ETF package to deliver what once required complex swap contracts. The idea that these products are inherently flawed is simply wrong.

So, it’s time for the Securities and Exchange Commission to start looking at ways of giving people clearance before trading such funds. There should be a way of ensuring that investors have a basic understanding of what they’re getting into—but the burden shouldn’t be on the creators of the products.

As long as I’m on the subject of suitability, exchange-traded products like the Barclays Long B Leverage S&P 500 TR ETN (NYSEArca: BXUB) and the Barclays Long C Leverage S&P 500 TR ETN (NYSEArca: BXUC) don’t rebalance daily and do in fact provide the extended leveraged exposure that some of these people were looking for.

That said, the last time I checked, even I wasn’t allowed to trade them in my Fidelity account—I’m guessing because of their lack of liquidity.

So, as far as the plethora of leveraged funds sponsored by ProShares and Direxion, here’s to hoping regulators pick up the slack that issuers were never meant to.

At the time this article was written, the author had no positions in the securities mentioned. Contact Ugo Egbunike at [email protected].


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