Leveraged ETF Ban Spreading Like the Flu

Recent trends in leveraged ETFs read a lot like the time-line for the swine flu.  For years the public has heard warnings from people who many dismissed as crackpots that it was only a matter of time before a strain of the flu morphed into a highly contagious virus causing a pandemic.  Then the swine flu strain emerged this spring, and municipalities across the country and the world finally took the threat seriously.  Once one municipality put certain guidelines into effect, others were quick to follow.

There has been a similar evolution in the world of leveraged ETFs.  Since the introduction of so-called triple leveraged ETFs late last year, we, along with others, have been highlighting their negatives and inefficiencies.  While they are only meant to track daily price changes, many investors hold onto them for more than a day, and that's where the problems arise.  The triple leveraged Financial sector ETFs from Direxion offer a perfect example.  The chart below shows the YTD performance of the 3X bullish (FAS) and the 3X bearish (FAZ) ETFs through July 16th.  In a period when the Financial sector is down 2%, not only is the 3x bearish ETF down, but with a decline of 88%, it is also down more than the leveraged long ETF!  So even if you correctly anticipated the direction of the Financial sector at the start of the year, you would have lost your shirt if you used these ETFs to implement your strategy.  Even more telling is that even though these ETFs are supposed to move in opposite directions, earlier this month both of them announced reverse splits.

  

For months, warnings from us and others about the use of these ETFs seemed to fall on deaf ears.  Even with the growing evidence that these ETFs were ineffective and a backdoor way for investors to use leverage, regulators and firms were largely silent on the issue.  Finally in June, FINRA and the Massachusetts Attorney General warned that these securities were unsuitable for investors to hold for more than a day. 

FINRA's warning seems to have struck a chord as several firms have begun to ban or severely curtail the ability of investors to buy and sell these securities in their accounts.  In the last few weeks, we have seen outright bans or severe restrictions put in place by firms such as Edward Jones, LPL Financial, Ameriprise Financial, and most recently UBS.  Now that the ball has been put in motion, investors in these ETFs should be aware that as more and more firms ban trading in them, liquidity is likely to fall, causing higher trading costs through larger bid ask spreads. 

Comments

[John]

Any EFT that is leveraged has decay. These funds are meant to be day traded, not held for a year.

Here is a quick explanation:
http://seekingalpha.com/article/119316-double-and-triple-etfs-decay-their-value-faster-by-design

[DL]

Rather than banning the purchase of ultra- and ultra-short funds, the brokerage firms should allow people to short them (most firms don't allow that). Shorting FAZ, for example, would have been highly profitable.

[Missing_Link]

Bespoke, you incompetent morons, why in the hell are you cheerleading those who want to ban leveraged ETFs? Leveraged ETFS are BRILLIANT for those who know how to use them properly.

Of COURSE you're not supposed to hold them for more than a few days! That hardly means they require legal protections.

Months-long graphs like the ones you show here only prove that you're intentionally trying to mislead people about their performance, and trying to cheerlead lawmakers into believing that leveraged ETFs need to be made unavailable to ordinary investors like myself, and that only Wall Street types like yourselves have the knowledge required to use them properly.

What absolute garbage!

You ought to be ashamed of yourselves for this fallacious and misleading argument which would remove one of the most powerful tools investors have.

You can have my leveraged ETFs when you pry them from my cold, dead TD Ameritrade account.

[Colin]

shorting Faz would have wiped you out if you did it in any size. why can't people understand the idea of delta.

[dj]

These babies are great for swing traders like me...if only we had these back in 2000

[Paul Hickey]

I don't think anyone was cheerleading. The article only pointed out that these ETFs have a lousy record of tracking their underlying indices on a long-term basis. Additionally, the fact that some firms are banning trading in them will lead to less liquidty. Investors should know that.
These securities do not accomplish anything that an investor with a margin account or options account can't already accomplish. While they do allow investors to use leverage where they otherwise couldn't (cash accounts,IRAs, etc), a much better solution would be to make the rules the same across the board.

[dj]

No,with leverage etf your pre paying the risk.A margin account you will pay after the fact ,an may have to sell something to cover the call... on options you have to deal with the P.T.E.,for swing trading these babies work just fine

[Jim Fellows]

TBT is up over 44% this year. It will likely be banned in wrap accounts at these firms and others. An obvious trade that worked quite well over multiple months. This is an outcome, just like the end of the "Merril Rule" ending fee in lieu of commission, that allegedly helps clients but actually hurts them.

The regulators will always be morons, and cater to the morons. This works out poorly for anyone with a brain.

Next on the agenda, banning ALL commodity etfs [long and *gasp* short]. Contango is too complicated for investors to handle.

[PD]

If you could collect income from your neighbor's house without owning it, that would be tough to give up.
Same for a brokerage on margin interest.

[Diago Echeverri]

what?