Rebalancing Act: A Primer On Leveraged and Inverse ETFs

Profession:NERA Economic Consulting

Article by By Raymund Wong, CFA, CPA, ABV and Kara Hargadon*

Overview A leveraged exchange-traded fund (ETF) is a financial instrument that seeks to deliver a daily return1 that is a multiple of the return of an underlying index, while an inverse ETF seeks to deliver a daily return equal to the opposite of the return of an underlying index. For example, a 2x leveraged ETF may seek to deliver double the daily returns of the S&P 500 Index, while an inverse ETF may seek to deliver the opposite of the daily returns of the S&P 500 Index. An ETF may be both leveraged and inverse, meaning that it seeks to deliver daily returns that are a multiple of the opposite of the underlying index's daily return.

The first issuance of leveraged and inverse ETFs in the United States included 12 funds issued in June 2006 by ProFunds Group.2 Since then, this class of ETFs has experienced substantial growth—by the end of June 2009, there were about 120 leveraged and inverse ETFs holding over $30 billion in assets.3 These types of securities have expanded to include funds that track currencies, commodities, and bonds. In the first seven months of 2009 alone, leveraged and inverse ETFs saw net cash inflows of over $20 billion even after regulatory actions likely decreased investor interest.4 Some leveraged and inverse ETFs are now among the most highly traded securities in the stock market. The Wall Street Journal noted that Direxion's Financial Bear 3X ETF experienced transactions of 23 million shares on 25 February 2009 "on only two million shares outstanding—implying an average holding period of less than 34 minutes."5

Perhaps due to the recent market turmoil, leveraged and inverse ETFs have become a popular tool for investors to hedge their positions or gain greater exposure to index movements.

Recent Developments In June 2009, the Financial Industry Regulatory Authority (FINRA) issued a Regulatory Notice to remind brokers and securities firms of their "sales practice obligations relating to leveraged and inverse exchange-traded funds." Citing the daily rebalancing feature of these securities, FINRA stated that they are "typically... unsuitable for retail investors who plan to hold them for longer than one trading session, particularly in volatile markets."6 Although FINRA followed up with a 13 July 2009 podcast that stated that a "sophisticated trading strategy that will be closely monitored by a financial professional... might require a leveraged or inverse ETF to be held longer than one day," regulators and financial institutions remain concerned about retail investor suitability. Several financial institutions have since issued their own warnings or restricted their sales of leveraged and inverse ETFs.7 On 31 July 2009, Massachusetts regulators sent subpoenas to four financial institutions—Ameriprise Financial Inc., LPL Financial Corp., Edward Jones, and UBS AG—seeking information on how these products are marketed to investors.8

On 18 August 2009, the Securities and Exchange Commission (SEC) and FINRA issued a joint alert because they "believe[d] individual investors may be confused about the performance objectives of leveraged and inverse exchange-traded funds." The SEC and FINRA stated that while leveraged and inverse ETFs have...

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