COLUMN-Burn Notice: Watch out for leveraged ETFs

Mon Dec 16, 2013 12:40pm EST

By John Wasik

CHICAGO Dec 16 (Reuters) - If you buy insurance on your home, you know that most of your losses would be covered in a catastrophe. Can you do the same with your portfolio?

There are lots of ways to buy portfolio insurance, but you have to be careful with leveraged exchange-traded funds (ETFs), which may offer protection, but carry a huge downside risk.

Leveraged ETFs have exploded in popularity in recent years as institutions and individuals are looking for ways to speculate and hedge positions after the 2008 meltdown. There are now more than 700 short or leveraged ETFs, topping $50 billion in assets, up from under 300 products and $28 billion in 2008, according to Boost, an independent exchange-traded product provider based in Britain.

Investors are drawn to these specialized ETFs on steroids because, through leverage, or derivative strategies, they can multiply their gains in a bull or bear market.

Want to bet on interest rates rising? If you have a large bond portfolio - which loses value when rates rise - you can buy a leveraged ETF such as the Direxion Daily 7-10 Year Treasury Bear 1X Fund. When rates rise, you make money on this fund.

As rates climbed earlier this year in reaction to possible Fed easing of its bond-buying policy, the Bear fund posted gains. For the year through Dec. 13, the fund is up almost 5 percent compared to a nearly 2 percent loss for the Barclays US Aggregate Total Return Index, which tracks a big slice of the U.S. bond market. The fund charges 0.67 percent in annual expenses plus brokerage commissions.

WHY LEVERAGED ETFS POSE HIDDEN RISKS

For most individual investors, the chance to turn a loss into a gain with one vehicle is an appealing one, but it is not without extensive risks. Since you can buy leveraged ETFs to cover slices of the stock market, there are myriad opportunities to bet on relatively small slices of the market, but you have to time your guess correctly.

Take the Direxion Daily Small Cap Bear 3X Shares, which offers an inverse return three times the Russell 2000 stock index. It would have been a great vehicle to own in 2008, when the S&P Index alone cratered 37 percent.

But times have changed and so has the stock market. The fund, which launched in 2009 at the beginning of a bull rally that has lasted to this month, has been nothing but heartbreak for those holding it long term. Its annual losses have ranged from nearly 80 percent in 2009 to almost 67 percent this year to date through Dec. 13. During the past five years, the fund's losses have averaged about 65 percent.

Ouch.

Although you would think that owning a fund that protects against disaster is a safe bet long term, the opposite is true for a number of reasons.

Leveraged ETFs are like aircraft - complex products that need to be fully understood before you buy and "fly" them.

In "daily" leveraged products, for example, the portfolio is rebalanced or "reset" daily so that the securities and derivatives reflect the index. That may erode return due to expenses and other factors.

And you may not get the returns you think you should because the fund managers are holding imprecise derivatives such as futures and swaps, which are sophisticated bets on prices. Performance may not even closely track the underlying index, particularly in volatile markets.

Then there's the ongoing bugaboo of timing the market. How do you know when a bull market ends and a bear market starts? Most leveraged ETFs are best suited for those focused on jumping in and out of a market to either hedge a position or speculate. That's why the institutions are bigger, more sophisticated users.

Institutions may only hold leveraged ETFs for a few days to a few weeks, says Kevin Cook, a senior stock strategist who trades and advises on leveraged ETFs for Zacks Investment Resarch in Chicago.

"Daily-return vehicles should be a red flag for the small investor who doesn't know how they work," Cook says. "Don't think of them as a hedge - they are more of a trading vehicle."

Despite numerous warnings and disclosures posted by major inverse ETF firms such as Direxion and ProShares, individual investors are still getting into trouble with these volatile vehicles.

Earlier this month, FINRA, the securities industry self-regulator, ordered Atlanta-based broker-dealer J.P. Turner Company, LLC, to pay more than $700,000 in restitution to 84 customers for "sales of unsuitable leveraged and inverse ETFs and excessive mutual fund switches." The company neither admitted nor denied the charges, but consented to FINRA's findings.

What if you want to hedge large positions of stocks and bonds and not worry about short-term volatility? You may want to consult a registered investment adviser, certified financial planner or chartered financial analyst to directly hold index futures contracts or change your portfolio mix. For this strategy to work, though, you'd need a customized approach in which you completely understand the downside.