Leveraged ETFs: Comprehension Is KeyOriginally 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.
Split Could Set Straight Two Direxion ETFsOriginally 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.
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.
Regulatory Storm Brews for ETFsOriginally 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.
"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.