As investors had trouble finding “better than average” returns in their “typical” investments in recent years, brokerage firms have tried to come up with alternative products and solutions touting solutions to this problem. One of these creations is Leveraged Funds or Leveraged ETFs (Exchange Traded Funds). Pitched as incredible tools that may accelerate wealth creation by returning multiples of returns of an underlying index, investments in leveraged funds/ETFs have grown exponentially over the past few years. The downside that is often NOT shared with investors: these funds are incredibly risky and could also lead to accelerated losses.
A leveraged fund/ETF uses financial derivatives (swaps, options, etc.) or debt (margin) to amplify returns of an underlying index. An example would be a leveraged fund/ETF that aims to perform at 2x the Dow Jones Industrial Index. If the Dow Jones Index (“DOW”) goes up 1%, the fund should go up 2%. However, if the DOW goes down 3%, the investor would incur losses of 6%. Although this seems straightforward, there is an additional complication. Most of these funds “reset” daily – something investors are rarely told. With this daily “reset,” an investor in a leveraged fund that tracks the DOW should not expect that just because the Dow was up 10% in a month, their investment will be up 20% for that month.
Thomas M. Anderson highlighted how this works in his article “The Dangers of Leveraged ETFs” published inKiplinger in January 2010. If the S&P Index were to go up 10% on Monday, and drop 10% on Tuesday, an investor in that Index is not at even money. With a $100 investment, the investor would be at $110 by the end of the day Monday ($100 + [10% of $100 = $10] = $110). By the end of the day Tuesday, however, the investment would only be worth $99 ($110-[10% of $110 = $11] = $99). But in a double-leveraged ETF, although the investment would soar to $120 on Monday, it would drop to $96 on Tuesday. So while an investor in the index itself lost $1, an investor in the leveraged ETF that should perform 2x the index is down $4. Joseph Slife and Mark Biller, in their article “Leveraged Funds: Enticing Idea, But ‘The Math Will Not Work,” published in Sound Mind Investing in September 2009, play this scenario out through day 6. In the traditional index fund, an investor would be left with $97.03, down approximately 3%. However, in the 2x-leveraged fund, the investment is left with $88.47, down approximately 11.5% in just 6 days! If this trend continues, the investor will find it more and more difficult to climb out of the hole he is in. Although this is a simplistic example, the analogy plays out accurately in real life. The losses compound more quickly than the gains.
In June 2009, the SEC and FINRA issued a joint Alert, “Leveraged and Inverse ETFs: Specialized Products with Extra Risks for Buy-and-Hold Investors.” This alert cautioned investors about Leveraged ETFs and asked them to consider all of the risks, read the prospectus, and work with an investment professional who understood their investment objectives, risk tolerance, and the workings of these complex products. A Wall Street Journal article reporting on the SEC & FINRA’s alert conveyed the thoughts of Paul Justice, an ETF specialist with Morningstar. Mr. Justice warned that leveraged and inverse funds are appropriate for less than 1% of the investing community;… and too many people are using these funds incorrectly.
Additionally, Leveraged Funds and ETFs typically charge investors larger fees than regular mutual funds. These funds are not suitable as long-term investments, and are generally recommended only for sophisticated individuals who can stomach a great deal of volatility and risk, or professional money managers who engage in active day trading.
If you have found yourself a victim of unfair brokerage activities relating to leveraged funds, call the lawyers of Page Perry for experienced representation at (877) 673-0047.