News Room
GETTING PERSONAL:
Leveraged ETFs Easily Misused, Advisers Say
By Daisy Maxey
July 17, 2009

NEW YORK (Dow Jones)--Brenda Wenning, a financial adviser in Newton, Mass., has seen firsthand the damage leveraged exchange-traded funds can wreak in the portfolio of an unsophisticated investor.

"A new client came in and had a leveraged ETF in his portfolio. He had an enormous loss, and he just sat with it," said Wenning, who launched Wenning Investments LLC in May 2008. "I'm like, 'Oh, my goodness; you can't do that.' They can complement your strategy, but I don't think they're intended for retail investors."

Wenning says she employs leveraged ETFs - complex instruments that can magnify not only investors' returns but their risks as well - very selectively, and plans to continue to do so, but does understand regulators' concerns about the investments.

Ian Naismith, a partner and mutual fund manager at Sarasota Capital Strategies in Osprey, Fla., regularly uses leveraged ETFs and leveraged mutual funds, mainly for hedging, but says they're not right for many retail investors and most advisers. They're a valuable tool if used prudently, but most advisors and retail investors won't monitor them as diligently as they should, he said.

"Before you know it, it's a nasty little downward movement in the market, and if they're not paying attention, it can have a severe effect on the portfolio," Naismith said. "They're only right for the adviser who looks at these items on a daily basis."

At various conferences, a lot of advisers tell Naismith "they got beat up on these things and they don't understand why," he said. Nevertheless, that's the fault of the adviser, not the ETFs, which are a useful tool in the right hands, he said.

ETFs trade daily on exchanges like stocks. Leveraged ETFs, sometimes labeled "ultra" or "2X," use futures or derivatives to multiply the daily returns of an index, sometimes striving to double or triple the return.

Lately they've come under the scrutiny of regulators. Whether that will put a chill on their use remains to be seen.

The Financial Industry Regulatory Authority reminded brokers and registered investment advisers in a June notice about their fiduciary duties when selling ETFs that offer leverage, are designed to perform inversely to the index or benchmark they track, or both. Finra reminded brokers and advisers that the instruments are complex and typically unsuitable for retail investors who plan to hold them longer than one trading session.

In addition, the office of Massachusetts Secretary of the Commonwealth William Galvin said earlier this week that it's investigating the sales practices associated with leveraged exchange-traded funds.

John Cox, director of alternative investments at Charles D. Haines LLC, a Birmingham, Ala.-based financial adviser, said the firm has mainly avoided leveraged ETFs because of their risk/return profile.

"Since the impact of a daily decline can be very significant, it can alter the ability of the leveraged ETF to generate the return that might be expected from a subsequent rise in the value of the asset that is tracked by the ETF," Cox said. "For example, if the price of oil goes up 10% over a one year period, an investor in a 2 times leveraged oil ETF might expect to recognize a 20% gain in his investment; however, based on the pattern of the oil price movement on a daily basis, the investor's return might be something well below 20%."

Louis Stanasolovich, president and chief executive of Pittsburgh-based Legend Financial Advisors Inc., said he uses leveraged ETFs in very small increments - typically from 1% to 2% of a portfolio - and finds them very useful to hedge the stock market from time to time.

In most cases, Stanasolovich said, leveraged ETFs are probably not something you hold for six months, and some shouldn't be held for more than a couple of hours. And he agrees that they aren't right for many retail investors and some advisers as well. "The general public thinks you just go out and buy an ETF, and that's all there is to it," Stanasolovich said.

Regulators should be questioning those who are using them to a large extent, just like those who have too much invested in the Standard & Poor's 500 index, he said.

Brenda P. Wenning is president of Wenning Investments, LLC of Newton, Mass. She can be reached at Brenda@WenningInvestments.com or 617-965-0680. For additional information, visit her blog at www.WenningAdvice.com.