Since their introduction in 2006, leveraged and inverse exchange-traded funds (ETFs) have taken in more than $20 billion in assets. "Leveraged ETFs" purport to magnify the move of a particular index, for example the Standard & Poors 500 stock index by double or even triple in some cases. So, a double-leveraged S&P 500 ETF is supposed to increase by 2 percent for a 1 percent increase in the S&P 500 index.

Inverse ETFs are supposed to move in the opposite direction of a given index. So, for example, an inverse S&P 500 ETF is supposed to increase by 1 percent for a 1 percent decrease in the S&P 500 index.

The steep decline in stock market indexes around the globe and increasing volatility created the perfect environment for leveraged and inverse ETFs. Now with these new vehicles, you could easily make money from major stock market indexes when they were falling. Or, if you were convinced a particular index or industry group was about to zoom higher, you could buy a leveraged ETF that magnifies market moves by double or even triple.

Suppose back in early 2008, when the Dow Jones Industrial Average had declined about 10 percent from its then recent peak above 14,000 you were starting to get nervous and wanted to protect your portfolio from a major market decline. So, you bought some of the ProShares UltraShort Dow 30 ETF (trading symbol DXD), which is an inverse ETF designed to move twice as much in the opposite direction as the Dow. So, if the Dow goes down, DXD goes up twice as much and you make money.

As you can see from the chart below, this ETF (blue line) did indeed rise sharply when the Dow (dark line) fell sharply in mid to late 2008. By late in 2008, with the Dow down about 40 percent, the ETF rather than being up 80 percent, was only up about 50 percent.

Now, examine what happened if you held on through early 2010 - two years after you bought the ETF in early 2008. Over this entire two-year period, the Dow was down about 20 percent so your original thinking - that the market was going to fall - proved to be correct. If the ETF did what it was supposed to do and moved twice as much in the other direction, it should have increased 40 percent in value over this period thus giving you a tidy return. But, it didn't - not even close. As the chart below shows, the ETF actually plummeted nearly 50 percent in value!
 

My overall investigations of whether the leveraged (and inverse) ETFs actually deliver on their objectives shows that they don't, not even close. In recent years, ETF issuers have come out with increasingly risky and costly ETFs. Leveraged and inverse ETFs are especially problematic in that regard.

Legal Troubles Brewing

And, now, the issuers of these leveraged and inverse ETFs are in trouble for their poor disclosure and misleading marketing. Buried in the fine print of the prospectuses of these ETFs, it usually says that these ETFs are only designed to accomplish their stated objectives for one trading day so they are only really suitable for day-traders! Of course, few investors read the dozens of pages of legal boilerplate in a prospectus.

What has landed these ETF issuers in legal hot water is what they fail to warn investors about. In a series of class action lawsuits filed by Stull, Stull & Brody on behalf of investors in ProShares leveraged ETFs, it says the following:

"The complaint alleges that ProShares and the other defendants violated the Securities Act by failing to disclose the following risks, among others, in the Registration Statement: (1) if Fund shares were held for a time period longer than one day, the likelihood of catastrophic losses was huge; and (2) the extent to which performance of the Fund would inevitably diverge from the performance of its index -- i.e., the overwhelming probability, if not certainty, of spectacular divergence."

 

In another suit, attorney Howard G. Smith announced a class action lawsuit has been filed in the United States District Court for the Southern District of New York, on behalf of investors in the UltraShort Real Estate ProShares fund ETF (trading symbol SRS). Here's what Smith said in his filing:

"As marketed by ProShares, Ultra ETFs are designed to go up when markets go up; UltraShort ETFs are designed to go up when markets go down. The SRS Fund is one of ProShares' UltraShort ETFs. The SRS Fund seeks investment results that correspond to twice the inverse (-200%) daily performance of the Dow Jones U.S. Real Estate Index ("DJREI"), which measures the performance of the real estate sector of the U.S. equity market. Accordingly, the SRS Fund is supposed to deliver double the inverse return of the DJREI, which fell approximately 39.2 percent from January 2, 2008 through December 17, 2008, ostensibly creating a profit for investors who anticipated a decline in the U.S. real estate market. In other words, the SRS Fund should have appreciated by 78.4 percent during this period. However, the SRS Fund actually fell approximately 48.2 percent during this period-the antithesis of a directional play."

Brokers Stepping Back from Leveraged and Inverse ETFs

Brokerage firms and industry regulators are taking notice of these problems. The Financial Industry Regulatory Authority (FINRA), the largest independent regulator for U.S. securities firms, issued a lengthy warning to brokers and financial advisors that included the following:

"...inverse and leveraged ETFs that are reset daily typically are unsuitable for retail investors who plan to hold them for longer than one trading session, particularly in volatile markets."

Retail investors have in fact pumped billions of dollars into leveraged and inverse ETFs without having had that explanation and disclosure. If they had, and if they had known how poorly these ETFs actually do over extended periods of time, they wouldn't have invested.

A number of brokerage firms including Ameriprise Financial, Edward Jones, LPL, and UBS have suspended trading in these ETFs. They are apparently worried about their legal exposure as well if their customers invest in leveraged and inverse ETFs and get burned.

The Bottom Line

Leveraged and inverse ETFs are not investments. They are gambling instruments for day-traders. Professional investors (hedge fund managers, for example), could use them as well for short-term purposes including hedging.

For you as an individual investor, it is possible that if you happen to guess right before a short-term major market move, you might do well over a short period of time (longer than one day but no more than a few months) but the odds are heavily stacked against you.

You can reduce risk and hedge yourself through sensible diversification. If you don't want 80 percent of your portfolio exposed to stock market risk, then invest a percentage you're comfortable with and don't waste your time and money with leveraged and inverse ETFs.  

 

Copyright Eric Tyson, 2008 - 2010 all rights reserved.

Eric Tyson is the only best-selling personal finance author who has an extensive background as an hourly-based financial advisor and who does not accept speaking fees, endorsement deals or fees of any type from companies in the financial services industry or product or service providers recommended in his articles, books and his publications.