UPDATE 2-Massachusetts begins probe of leveraged ETFs

* Sales practices of leveraged ETFs facing state probe

* Three firms that structure the funds were sent letters (Adds comment from ProShares)

By Jason Szep

BOSTON, July 15 (Reuters) - Massachusetts' top securities regulator has begun a probe into the sales practices of three firms that sold leveraged exchange-traded funds, a derivatives cocktail that can reap double or triple an assets' daily returns.

Massachusetts' Secretary of State William Galvin said in a statement on Wednesday that he had sent letters to three firms heavily involved in structuring these funds: Rydex Investments, Direxion Funds and ProShares.

Traditional exchange-traded funds trade like stocks, but track an underlying index or basket of assets. Leveraged ETFs use a formula of options and other derivatives to yield two or three times the profit when underlying assets fall or rise.

The funds, which have exploded in growth, also have faced scrutiny in recent weeks by the Financial Industry Regulatory Authority, the industry's own watchdog. [ID:nN0272780]

"Since 2006 these products have become increasingly popular. Yet, due to the daily nature of the leverage employed, there is no guarantee of amplified annual returns and they generally incur greater transactions costs than traditional exchange traded funds," Galvin said.

Their enormous popularity, and the pummeling that stocks took after Lehman Brothers went bankrupt in September, has led some investors to question whether the leveraged ETFs contributed to the stock market's steep plunge from late September through March.

They often use derivatives such as index options, index futures, total return swaps and equity swaps to increase or reduce market exposure.

"Because these leveraged exchange traded funds are reset every day, buy and hold investors often find that their returns vary greatly from those of the corresponding index," Galvin said. "So it is important that retail investors be provided with all the information necessary to make informed choices about these products.

"That is why the Securities Division of this office plans to conduct a review of the sales materials which are provided to Massachusetts investors and further assess the compliance procedures and supervision of Massachusetts broker-dealers offering these securities to retail investors," Galvin added.

A May report by Barclays Global Investors said the daily rebalancing of levered ETFs exacerbated the volatility of underlying indexes and securities that comprise the indexes.

The U.S. Securities and Exchange Commission received 221 letters critical of the leveraged ETFs after it recently sought comment on how to address short-selling.

ProShares is part of ProFunds, the leading provider of nontraditional ETFs. Investments in ProFunds' nontraditional ETFs surged to $27.5 billion in June from zero just three years.

"We are confident that ProShares' sales and marketing materials are accurate and meet applicable regulatory requirements," said a statement from ProShare Advisors LLC.

"ProShares ETFs have performed consistent with their daily investment objectives as fully described in the prospectus. Mr. Galvin has made a request for information and we intend to fully cooperate with this request."

(Reporting by Jason Szep; Additional reporting by Herbert Lash in New York; Editing by Gerald E. McCormick, Phil Berlowitz)