A Panacea for Leveraged ETF Woes?

Direxion, creator of the enormously popular Daily Financial Bull 3X(FAS Quote) and Daily Financial Bear 3X(FAZ Quote), is making changes to its mutual funds that may cast a shadow on its ETF business.

In a supplement to the mutual fund prospectus of 17 leveraged mutual funds, Direxion has announced it will be changing its tracking strategy from a daily to monthly time frame. In addition to extending the index timeframe, Direxion will also be lowering the leverage for some of the funds to 200% from the current 250%.

As leveraged ETFs come under attack from both regulators and individual investors, the primary complaint has been the tracking error of the double-down or triple-down funds. While these funds track their underlying indices on a daily basis, over the longer term compounding can erode the funds.

The controversy surrounding the daily tracking of leveraged ETFs prompted regulator FINRA to issue a notice back in June:

"while such products may be useful in some sophisticated trading strategies, they are highly complex financial instruments that are typically designed to achieve their stated objectives on a daily basis. Due to the effects of compounding, their performance over longer periods of time can differ significantly from their stated daily objective. Therefore, 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."

Following the FINRA release, several large brokerage houses including Ameriprise(AMP Quote) and UBS(UBS Quote) halted the sale of leveraged products to investors.

One possible solution to the leveraged fund frustration would be to extend the tracking time frame of the underlying index. Since daily tracking funds are not suitable for average buy-and-hold investors, ETF issuers could create longer term contracts that seek to match returns on a monthly or even multi-month basis.

The buy-and-hold investment industry, championed by mavens like Warren Buffett, is a trillion-dollar business that ETF issuers have not ignored. Earlier this year Charles Schwab(SCHW Quote) announced that it would be issuing its own proprietary line of ETFs that mimic traditional buy-and-hold mutual fund strategies. Other issuers have launched life-cycle ETFs and hedge-fund strategy ETFs.