More Official Warnings on Leveraged ETFs (FAS, FAZ, UYG, SKF, SDS, SSO)

The Financial Industry Regulatory Authority and the Securities and Exchange Commission decided to issue an Investor Alert yesterday called “Leveraged and Inverse ETFs: Specialized Products with Extra Risks for Buy-and-Hold Investors”….  This warning was meant to warn retail investors of the added risks in leveraged ETF investments that exist above and beyond the traditional world of investment products. This follows a recent FINRA regulatory notice reminding securities firms and brokers of their sales practice obligations relating to leveraged and inverse exchange-traded funds.

While this is not against any single leveraged ETF (or inverse ETF), it may have at least some influence on leveraged ETF and reverse-leveraged ETFs.  The two key ETFs for leverage and high volume and high volatility are the Direxion Daily Financial Bull 3X Shares (NYSE: FAS) and the Direxion Daily Financial Bear 3X Shares (NYSE: FAZ) as they are the 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.

Before you go out and worry too much about how many warnings are out there, the industry itself has been making more warnings of its own.  Direxion was either the first or one of the first to come out with a detailed analysis of how its ETFs have performed differently than the target index through time.  They have even engaged in a reverse stock split to curb some of the volume and volatility that is inherent with such low-priced stocks.  Direxion even warned how these are not to be held by long-term investors, so our own take on this is they have gone above and beyond their duty of warnings on how these act.

John Gannon, FINRA Senior Vice President for Investor Education: “Not all ETFs are created equal… leveraged and inverse ETFs can deviate substantially from the performance of the underlying benchmark…. that can turn into a minefield for buy-and-hold investors.”

The FINRA/SEC warning reminds investors that leveraged and inverse ETFs “pursue a range of investment strategies through the use of swaps, futures contracts and other derivative instruments.” It also notes that most leveraged and inverse ETFs reset daily as they strive to achieve the gain or loss performance on a daily basis.

The FINRA/SEC warnings also used the Direxion example of how the returns have differed through time.  The warning advises investors to consider these products only if they are confident the product can help meet their investment objectives and they are knowledgeable about and comfortable with the risks associated with these specialized ETFs.

In short, there is nothing different now about these products for active traders and day traders.  There is just a much deeper understanding by the public that 3X return goals might not generate a real 3X return through time.

JON C. OGG
August 19, 2009