Some brokerage firms are banning the sale of leveraged and inverse ETFs. They claim to be taking these steps out of concern for their clients, but the facts paint a different picture. This story has been 16 years in the making. Why all the fuss now?
In June, FINRA issued a warning to brokers and investment advisors regarding leveraged and inverse ETFs. We predicted at the time that brokerage firms would likely place some restrictions, but we never envisioned a total ban. We reported the release from FINRA contained something that ought to put a chill up the spine of leveraged ETF marketing executives: “…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.” This is legal-speak for “Don’t sell these to anybody except day traders.”
By July it was apparent that the FINRA warning had a greater impact on the legal departments of the brokerage houses that sold these products than on the leveraged ETF marketing executives. After all, the ETF sponsors have long warned of the dangers that can come from misusing these products and all provide warnings and educational material. Here are links to such information for DirexionShares, ProShares, and RydexShares.
Edward Jones was the first to ban/cut leveraged ETFs from their lineup according to a July 21 article in the Wall Street Journal. Next came reports that LPL Financial, Ameriprise Financial, and UBS were also banning the products.
I’m not sure what their real motives are, but the actions taken by these brokers seem insincere. Here are some of the reasons why I feel this way:
- Funds that use a “daily reset” of their leverage and inverse exposure are nothing new. The first leveraged fund was Rydex Nova (RYNVX), launched in July 1993 (16 years ago). Rydex Ursa (RYURX), the first inverse fund, came out six months later in January 1994 (note: Ursa has since been renamed Rydex Inverse S&P 500 Strategy).
- In late 1997, ProFunds introduced 2x long and 2x inverse funds that reset their target exposure on a daily basis. This was nearly a dozen years ago. Leveraged and leveraged inverse funds are nothing new.
- The math has not changed. The mathematics were the same in September 1994 when RYNVX and RYURX were both showing year to date losses. The mathematics were the same in the early part of this decade when 2x long ProFunds Ultra Nasdaq 100 (UOPIX) and 2x inverse ProFunds UltraShort Nasdaq-100 (USPIX) both had double digit losses while the underlying index had a gain.
- Many, if not most, of the brokers that have banned leveraged and inverse ETFs still offer leveraged and inverse mutual funds. When it comes to daily reset of leveraged and inverse exposure, there is no difference between ETFs and mutual funds.
- Many, if not most, of the brokers that have banned leveraged and inverse ETFs still offer put and call options to their clients. It is a well known fact that many options expire worthless and investors lose 100% of their investment (plus commissions). To my knowledge, no leveraged or inverse ETF has ever lost 100% of its value. Options are more risky than leveraged ETFs.
- Many, if not most, of the brokers that have banned leveraged and inverse ETFs still offer short selling to their clients. It is a well known fact that short-selling is risky and the potential loss can be well in excess of your entire investment. With inverse ETFs, your risk is limited because no ETF has ever lost 100% of its value. Short selling is more risky than leveraged ETFs.
- Many, if not most, of the brokers that have banned leveraged and inverse ETFs still offer margin accounts to their clients. It is a well known fact that margin accounts are risky and the potential loss can be in excess of your entire investment. The value of your leveraged and inverse ETFs should never decline by more than your investment. Margin accounts are more risky than leveraged ETFs.
The fact is that the “daily reset” of leverage actually protects investors from blowing themselves up. It prevents a position from going to zero, it prevents margin calls, and it prevents the unlimited loss potential of short-selling.
These products should not be banned. They should be hailed as great achievements in risk management. They are actually protecting investors from themselves.
Disclosure: I currently own a few leveraged and inverse products. I have been using them since 1994, and they have always performed as stated in the prospectus.