Leveraged ETFs: More Regulation

The Royal Bank of Canada has put additional restrictions on double- and triple-leveraged ETF products.

In addition to providing a possible glimpse of what's to come in the U.S., the move underscores the risk and complexity of these ETFs, something investors should be aware of regardless of whatever regulations are in place.

The new Canadian regulations limit the purchase of these leveraged ETFs to investors who are already approved for options trading.

Leveraged ETFs, which utilize complex derivative instruments like futures or swaps to achieve their investment objectives, seek to amplify the returns of their underlying indices. Some are bearish, which means they multiply the inverse of an index's moves. An example of a bullish leveraged ETF is the Direxion Daily Financial Bull 3X ETF(FAS), which is designed to give investors 300% exposure to the Russell 1000 Financial Services Index on a daily basis. The Direxion Daily Financial Bear 3X ETF(FAZ), on the other hand, is designed to provide inverse 300% exposure to the same index.

As leveraged ETFs have become popular, regulators in both the U.S. and Canada have expressed concern about the complexity of these securities and have examined different ways of restricting their sale.

Since these funds offer leveraged exposure to their underlying indices on a daily basis, a compounding effect occurs when the funds are held long term. While most investors use triple-leveraged funds like FAS and FAZ to hedge daily exposure, investors who hold the funds for more than one day may not get the returns they are expecting.