Top ETF Stories of 2009: Leveraged Funds

NEW YORK ( TheStreet) -- Leveraged exchange-traded funds made for one of the most important stories in the ETF universe in 2009.

Following are three of my most popular 2009 articles on leveraged ETFs. ( Here are my most popular articles on another hot ETF topic of the past year, natural gas.)


Leveraged ETFs: Comprehension Is Key

Originally published 06/25/09 09:00 AM EDT

The controversy surrounding ultra long, ultra short and other leveraged ETFs has reached a fever pitch while the funds, particularly the Direxion Financial Bear 3x ETF ( FAZ) and Direxion Financial Bull 3x ETF ( FAS), continue to grow in trading volume.

While leveraged ETF funds are not a new phenomenon, they have hit the mainstream and have drawn the attention of regulatory agencies like FINRA and commentators asserting that investors should be protected against these products. Like all financial tools, the power of leveraged ETFs is truly in the hands of the investor, and the danger lies in an investor's unwillingness or inability to understand them.

Quite often investors don't get what they expect when investing in ultra long or ultra short ETFs and are confused when, over time, their fund fails to track the objective that is advertised. In a Wall Street Journal article, Paul Justice, an ETF specialist for Morningstar ( MORN) recently noted that Since most leveraged ETFs "reset" each day, it is difficult to gauge long term returns; twice the daily return of an index is not twice the monthly return.

"When employing leverage and compounding returns, an investor would have to know how volatile and in which direction the daily price swings will be--which is nearly impossible--to know how he will fare beyond one day," Justice said.

This encapsulates the complex nature of the leveraged funds and the way in which alternating market currents can erode leveraged funds over time. Examples of this include the widely traded FAS and FAZ. Even though the two are opposite and track three times the Russell 1000 Financial Services Index, both funds are down year-to-date. The bear fund, FAZ, is down 85% year-to-date, according to FactSet Research. The bull fund, FAS, is down 67% in the same period.

Until just recently, the biggest problem with leveraged ETFs was that most retail investors didn't appreciate how leveraged funds were designed to work or the dangers involved in trading them. When ETFs were introduced they brought a refreshing level of transparency to the marketplace and to every day investors. ETFs are associated with low fees, passive strategies and transparent portfolios.

As the ETF industry has grown, however, increasingly complex products have been introduced. Many investors still associate these complex products with the initial, easy-to-grasp index ETFs that jump-started the ETF world. This is the difference between matches and a blowtorch -- both will start a fire, but they will do it in very different ways and to very different degrees. The distinction would be very important when telling someone which one to get.

This confusion, however, does not apply to just leveraged ETFs. Exchange-traded notes (ETNs), which are composed of debt instead of equity, were recently introduced into the ETF marketplace along with funds that use futures to track commodities like oil ( USO) and natural gas ( UNG). These funds should be put in a separate category from "regular" (stock index-based) ETFs. The acronym "ETN" is dangerously close to the word "ETF," and it is not surprising that new investors would assume that new ETFs play by the same rules as their predecessors.

ProShares was the original purveyor of leveraged funds and Michael Sapir, chairman and chief executive of ProFunds Group, is naturally defensive about the recent backlash. Sapir asserted in a recent Wall Street Journal article that leveraged funds are "not more complicated than numerous funds in the marketplace used by retail investors and recommended by brokers."

He has a point. Futures-based commodity ETFs also employ a potentially dangerous level of complexity, while ETNs expose investors to risk they don't always understand. Older ProShares leveraged funds such as UltraShort Real Estate ( SRS), UltraShort Financials ( SKF) and Ultra Financials ( UYG) employed a somewhat simpler methodology than their contemporary peers. As it is impossible to generalize about the nature of all ETFs, it is also impossible to generalize about the nature of leveraged ETFs.

Leveraged ETFs can be useful tools for professional traders looking to hedge positions on an intraday basis. These funds have been marketed to the public, however, and until recently the image has been somewhat deceptive.

FINRA posted a warning on its Web site earlier this month about leveraged ETF products, and increased regulatory scrutiny is likely coming down the line. No one would argue that matches and blowtorches are the same thing -- but there is a place for both in harnessing the power of fire. There is a place for both leveraged and index ETFs, but investors must understand which ones they need.


Split Could Set Straight Two Direxion ETFs

Originally published 07/07/09 09:00 AM EDT

The combination of market volatility and the methodology of Direxion Shares Daily Financial Bull ( FAS) ETF and Direxion Shares Daily Financial Bear ( FAZ) has eroded the per-share value of these ETFs, prompting the issuer to notify investors of reverse splits planned for July 8.

The low price of FAZ and FAS, approximately $5 and $8 respectively, has caused a surge of volume in the funds in recent months as investors require more shares to meet intraday hedging objectives. The pending reverse split of the shares should lower transaction fees for frequent investors while discouraging investors who should avoid the funds in the first place.

FAS and FAZ were launched by Direxion in November of 2008, as measures of volatility reached incredible peaks. As investors were looking for even greater means to bet on the market's intraday moves, Direxion introduced the two triple-leveraged funds, which provide 3 times exposure for shareholders on a daily basis. Because the funds have a daily "reset" in their tracking of the market, risk that a long-term loss will result grows over time.

In one of my recent articles, "Big Action in Triple-Leveraged ETFs," I discussed how math can work against long-term holders of leveraged ETFs. Because the funds only track returns on a daily basis, a percentage move down that follows a percentage move up can be detrimental. Case in point: FAS, the 3 times bull ETF, is down more than 67% year-to-date while its bearish peer FAZ is down nearly 86%. Clearly, these ETFs do not track the movement of the actual market over time.

Direxion Shares and Direxion Funds, managed by Rafferty Asset Management is the issuer of leveraged index funds, ETFs and alternative-class fund products for investment advisors and sophisticated investors who seek to effectively manage risk and return in both bull and bear markets. Founded in 1997, the company has approximately $6.5 billion in assets under management as of May 31, 2009. Disclosure available on the company's Web site further specifies that the products are intended for advanced investors only.

On Wednesday, July 8, Direxion will execute a 1-for-5 reverse split of the shares of FAS and a 1-for-10 reverse split of the shares of FAZ. Because of the split, some investors will be left holding fractional shares that cannot be traded on NYSE Arca. According to Direxion's press release:
Thus, FAS and FAZ will redeem for cash a shareholder's fractional shares at the Funds' respective split-adjusted NAVs as of July 8, 2009. Such redemptions could cause a shareholder to realize a gain or loss in connection with the redemption of the shareholder's fractional share. Otherwise, the reverse split will not result in a taxable transaction for holders of FAS or FAZ shares. No transaction fee will be imposed on shareholders for such redemption.

Direxion will provide a one-time opportunity for shareholders to redeem their odd-lot shares. While the split will hike up the price of FAS and FAZ, potentially discouraging some investors from scooping up shares, further market volatility could erode the price of FAS and FAZ once again in the future.

The reverse split in FAS and FAZ should dampen the explosion in volume that the funds have seen in the past few months. Since the share price of FAS and FAZ has been so low -- approximately $8 and $5, respectively -- investors have had to buy more and more shares to have equivalent investments.

The drop in price has also potentially attracted investors who do not belong in leveraged funds. With higher share prices and lower share volume, the headlines for these funds may finally become representative of their actual meaning to the market.

In a Q&A available on their website, direxionshares.com, the issuer notes that the reverse split could be beneficial to their shareholders. The primary reason that Direxion is completing the split is the fees that are currently incurred by shareholders. Direxion notes:
The bid-ask spread is expected to decline as a percentage of the price paid per share. For instance, a penny spread on a $5 stock is 20 basis points (0.2%), while a penny spread on a $50 stock is 2 basis points (0.02%). Further, commissions charged by brokers who assess their clients on a per share basis will be smaller as investors will need to buy or sell fewer shares to meet their investment goals. In short, Direxion believes that the reverse splits will adjust the share prices to a more cost efficient level for the Funds' shareholders.

While investors may begrudge the taxable event that will result from redeeming odd-lot shares in the wake of the split, the reduction in transaction fees may be a satisfying reward.

Direxion's reverse split will reduce fees and refocus investors in the short term, but due to the nature of the funds, long-term problems will remain. The split will prop up the funds' price for now, but erosion could haunt investors once again. In the meantime, it is more important than ever for investors to focus on the true purpose of the funds: as an intraday hedge for sophisticated investors.


Regulatory Storm Brews for ETFs

Originally published 08/20/09 09:06 AM EDT

A regulatory storm is brewing on the horizon, and the first drops of doubt are beginning to fall on the ETF industry. Both brokers and issuers are running for cover before the skies open up. Lawsuits, like lightning, could strike at any time, singling out a firm from the herd and driving deep cracks into the industry floor.

Starting with a small firm called Edward Jones, brokers have bowed out of the leveraged ETF arena. Despite increasingly revealing warning labels, the wrong kinds of investors continue to get dragged into ultra-long or triple-down funds.

Like many medications, leveraged ETFs were designed to treat specific conditions. Daily leveraged funds like Direxion's Daily Financial Bull ( FAS) or ProShares UltraShort Financials ( SKF) are designed to be used with existing portfolios to provide hedging capabilities. Long real estate? Hedge your portfolio over a single trading day with the purchase of ProShares UltraShort Real Estate ETF ( SRS).

These useful remedies, however, can sometimes fall into the wrong hands or be taken for the wrong reasons. The heady rush of being ultra-long or ultra-short has proven to be a temptation too great for some investors who rushed to their brokers to get their fix. Once difficult to access, these strategies have been made available by the structure of ETF products.

The Hippocratic oath of doctors does not extend to the offices of Wall Street, and questions have been raised about the dispensing of these ETF products. Not wanting to be seen as irresponsible drug dealers, brokerage firms are washing their hands of leveraged ETFs before the financial DEA comes knocking. Firms like UBS ( UBS) and Ameriprise ( AMP) have bowed out of the leveraged ETF business.

Fear of regulation has spread to the ETF industry as well. The U.S. Natural Gas ( UNG) ETF recently declined to issue additional shares despite a request for these very same shares only a month before. During the period in between the request and the SEC's response, another financial regulatory authority, the Commodities Futures Trading Comission (CFTC), got involved.

Economic downturns and the collapse of financial bubbles are a breeding ground for finger-pointing. One group that has been targeted with a vengeance are the "speculators." Whether the headline is housing or commodities, the shadowy figures of speculators seem to haunt the recesses of plotlines across the industry. One of the places that speculators seem most at home is the commodities futures markets.

The CFTC is the sheriff in that town and this agency has been monitoring a new bully in the commodities markets. Funds like UNG and U.S. Oil ( USO) use futures contracts to track their objectives. These funds have become so popular so fast that they now represent a significant segment of the open interest in these markets.

The CFTC has begun to examine whether these funds could be dictating these commodities markets, rather than tracking them. While upcoming regulation could take many forms, a likely incarnation will be position limits.

UNG managers watched closely during July as these details emerged, gradually battening down the hatches and shifting position. When the SEC finally granted its request for new shares, UNG wasn't about to take the bait. Fear had taken hold and UNG does not want to increase its bet on the table if the rules could change midgame.

Thus far, the fear of regulation has succeeded in idling a major natural gas ETF in the middle of rush hour traffic and sending brokers running for the hills. Both brokers and issuers will protect themselves from lawsuits and regulation before reaching out to investors.

Neither party will go gently into the night. ProShares and Direxion have defended their products, and Charles Schwab himself recently stepped forward to question regulation. In a recent Wall Street Journal editorial, Schwab noted:
"I've always believed in the power of the market to drive innovation and drive down cost. I also believe in the individual and his or her ability to make reasoned decisions. I don't think our clients, or our competitors' clients, are looking for regulators or politicians to protect them from risk by constraining their choices."

Schwab's comments suggest that some brokers may not restrict their product offerings on the basis of intimidation.

ETFs, like drugs, should not all be dispensed in the same manner. Traditional ETFs, like Tylenol, should be available to all investors. The warning on the box plus a childproof cap should be sufficient to prevent a widespread misuse of traditional funds.

Nontraditional ETF strategies, like prescription drugs, should require additional documentation. I've called for restricting access to leveraged ETFs to only those investors cleared for margin or options trading. These aren't suitable for unsophisticated do-it- yourself investors.

While the regulatory storm so far has been a lot of thunder and no lightning, the noise has succeeded in disrupting the ETF industry. Regulators should react or fall silent so that brokers, issuers and ETF investors can go on with their lives.

-- Written by Don Dion in Williamstown, Mass.

A special note from Don: Jim Cramer himself says, "No one else knowsETFs like Don Dion." And now you can benefit from my ETF expertise.My new service TheStreet ETF Action by Don Dion can helpinvestors at all levels profit from the world of ETFs. Click here to be eligible for a charter membership.Space is limited, so act now.

At the time of publication, Dion had no positions in equities mentioned.

Don Dion is president and founder of Dion Money Management, a fee-based investment advisory firm to affluent individuals, families and nonprofit organizations, where he is responsible for setting investment policy, creating custom portfolios and overseeing the performance of client accounts. Founded in 1996 and based in Williamstown, Mass., Dion Money Management manages assets for clients in 49 states and 11 countries. Dion is a licensed attorney in Massachusetts and Maine and has more than 25 years' experience working in the financial markets, having founded and run two publicly traded companies before establishing Dion Money Management.

Dion also is publisher of the Fidelity Independent Adviser family of newsletters, which provides to a broad range of investors his commentary on the financial markets, with a specific emphasis on mutual funds and exchange-traded funds. With more than 100,000 subscribers in the U.S. and 29 other countries, Fidelity Independent Adviser publishes six monthly newsletters and three weekly newsletters. Its flagship publication, Fidelity Independent Adviser, has been published monthly for 11 years and reaches 40,000 subscribers.

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