Brokers Ban New Kind of "Dangerous" ETF

Kyle Hartman's picture

Friday, July 31, 2009 - 11:12am

by Kyle Hartman

In a bid to protect investors from an often misunderstood financial instrument, UBS, Edward Jones and Ameriprise Financial banned clients from purchasing leveraged ETFs this week.

Company Available Broker Sales
Merrill Lynch Yes Limited
Scottrade Yes No
E-Trade Yes Yes
TD Ameritrade Yes Yes
UBS No No
Edward Jones No No
Ameriprise Financial No No
Morgan Stanley Yes No
Wells Fargo Yes No
Bank of America Yes No
Charles Schwab Yes No
Fidelity Yes No

A leveraged ETF seeks to return a multiple of the fund’s underlying benchmark. If an ETF tracks the S&P 500, for example, and the S&P gained +5% in a day, then the fund would gain +10%. Other funds may use even more leverage. Others seek to generate an inverse multiple, gaining when the index falls and vice versa. But Finra -- the financial industry's internal beat cop -- notes that leveraged ETFs don't accurately track their benchmarks over time.

That’s true. The Dow Jones U.S. Oil & Gas Index, for instance, gained +1.6% from Dec. 1 to April 30. The conventional wisdom is that the leveraged ETF that tracks the index, the ProShares Ultra Oil & Gas (NYSE: DIG), should have doubled that performance and returned +3.2%. It didn't; it fell -5.6% instead.

But this isn't wrongdoing. Nobody's going to jail over this. It’s not even a tracking error. Leveraged ETFs were designed for short-term traders. The funds are meant to "reset" every day. They were never intended to be held for the long term to mirror an index’s long-term performance -- a point some individual investors evidently didn't get.

In June, Finra said in a regulatory notice that leveraged ETFs were unsuitable for individual investors who planned to hold them for longer than one day, a risk that's been clearly outlined in ProShares' prospectus for DIG all along. Finra, which looks after brokers and dealers and not individuals who trade for their own account, has since backtracked a little and said that holding leveraged ETFs for longer than a day might be suitable in some cases.

The point of all this should be clear: Investors need to know what they're getting into.

No one likes to read the prospectus, and brokerages know that, so they’ve tried to solve the problem of investor ignorance by moving the funds out of reach. You can decide whether that’s a good move. But even a cursory glance at the risk factors for DIG would have shown an investors that the ETF wouldn't accurately track the index over time.

The best rule is this: The more complex the financial instrument, the more due diligence an investor should perform before buying. A leveraged ETF might be just what you're looking for, but if you're not actively looking for it, then it's probably not the best thing to have in your portfolio.

If you're not sure if you have a leveraged ETF in your portfolio, don't worry: They're easy to spot. These funds usually have something in their name that's a dead give-away: Words such as "ultra," "leveraged," "2X" or "3X." There are a fair amount of them out there: Investment companies have created 212 so far. They hold more than $32.8 billion in assets.

Kyle Hartman does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.