The movement against, or at least a move to better quantify, leveraged ETFs is still going.  In fact, it is becoming more clear.  While this is not against any single leveraged ETF (or inverse ETF), this does have at least have a continued influence on leveraged ETF and reverse-leveraged ETFs such as the Direxion Daily Financial Bull 3X Shares (NYSE: FAS) and the Direxion Daily Financial Bear 3X Shares (NYSE: FAZ).  Those are triple-leverage financial sector ETFs. A handful of the other active leveraged and inverse-leverage ETFSs are as follows: Ultra Financials ProShares (NYSE: UYG) seeks twice the daily performance of the Dow Jones U.S. Financials index.  UltraShort Financials ProShares (NYSE: SKF) seeks twice the inverse of the daily performance of the Dow Jones U.S. Financials index. UltraShort S&P500 ProShares (NYSE: SDS) seeks twice the inverse of the daily performance of the S&P 500 index. Ultra S&P500 ProShares (NYSE: SSO) twice the daily performance of the S&P 500 index.

This morning came an announcement from Morgan Stanley Smith Barney that it has placed certain restrictions on the sale of leveraged, inverse, and leveraged inverse exchange traded funds.  The reason even started out as “In response to concerns raised by regulators about these securities…”

The firm has noted that as of today, solicited purchases of these products will not be permitted in traditional brokerage accounts. Furthermore, it noted that unsolicited purchases in these accounts will be permitted only subject to enhanced oversight and review.  Lastly, the firm has noted that no purchases of these securities will be permitted in advisory accounts managed by Morgan Stanley Smith Barney Financial Advisors.

Morgan Stanley Smith Barney went on to note that Financial Advisors have also been encouraged to review existing positions in these securities with clients to emphasize their unique characteristics and risks.

We placed a call into the firm to see if this had become a large portion of the brokerage business in trading volumes, but the standard “we would not disclose that data” was all we got from the media relations.  It is hard to imagine that brokers and advisors of the firm would be actively pushing these leveraged and inverse-leverage ETFs to their clients regularly.  In fact, our take on this is that this is more of a “CYA” statement for internal purposes.  After all, this does not create an outright ban on these products.

What is interesting is that at least some of the managers of these ETFs have been vocal about the risks and have even demonstrated how through time these will not necessarily correlate to the exact or expected returns of the underlying indexes.  Direxion, in our opinion, gave one of the best disclosures that an ETF manager could give.  It said in a formal filing, “Particularly in periods of heightened volatility, the ETFs should be used by investors as short-term trading vehicles. As a consequence, we do not believe that investors should buy and hold the funds.”

With the inquiry from Massachusetts already out in the world of leveraged ETF products, we would expect more firms out there to adopt similar internal regulations or restrictions.  And the overall impact or effect it may have, that is probably minimal.

JON C. OGG
AUGUST 7, 2009

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