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.