Are Leveraged ETFs Too Dangerous for Individual Investors?

May 17th at 9:01am by John Spence

Leveraged ETFs that magnify the market’s performance are facing more scrutiny. There are calls they should come with warnings or even that individual investors should be prohibited from buying the complex products.

“The starting point for regulators is to consider whether individuals should be able to buy a leveraged ETP [exchange traded product] with just a click of a mouse without at least affirming that they understand it is an especially complicated and risky investment,” wrote Tom Lauricella in a recent Wall Street Journal article. [Cleveland Fed Questions Market Risks of ETFs]

Regulators and the media are questioning leveraged and inverse ETFs after the meltdown in VelocityShares Daily 2X VIX Short-Term ETN (NYSEArca: TVIX) in March, when the exchange traded note quickly lost 60% of its value. [Leveraged ETFs on the Hot Seat]

The SEC is probing the ETN’s swift decline that occurred when its premium collapsed. The product is designed to double the daily performance of CBOE Volatility Index futures contracts. [Caveat Emptor – Volatility ETFs]

The providers of leveraged and inverse ETFs say their products are designed to magnify the market’s returns on a daily basis, and are not designed for long-term investors.

“These products seek a daily goal,” said Andrew O’Rourke, chief marketing officer of Direxion Funds, in a recent InvestmentNews report. “They are absolutely not buy-and-hold investments and should not be viewed through the same lens as a typical buy-and-hold mutual fund.”

WSJ’s Lauricella thinks warnings for individual investors before purchasing leveraged ETFs are appropriate.

“After all, when investors use another form of leverage—margin accounts—brokerage firms are mandated to provide upfront disclosure about the risks involved. Margin accounts also have mandated limits designed to protect investors,” he wrote.

“Perhaps a better question for regulators is why leveraged ETPs should even be accessible to small investors. Might regulators take a page from hedge-fund rules and limit leveraged ETPs to ‘accredited investors’ with a net worth of $1 million? Or to professional investors and traders?” Lauricella added.

The idea of regulators placing restrictions on leveraged ETFs is speculation at this point.

The Financial Industry Regulatory Authority recently fined four brokerage firms a collective $9.1 million over improper sales of leveraged and inverse ETFs.

Leveraged and inverse ETFs and ETNs account for a tiny fraction of the total $1.2 trillion exchange traded product business in the U.S. At the end of April, leveraged and inverse products held about $31.5 billion in assets, according to ETF Industry Association data.

The opinions and forecasts expressed herein are solely those of John Spence, and may not actually come to pass. Information on this site should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product.

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