September 6, 2013 7:36 pm

Inverse and leveraged products take a beating

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Class action: the federal court of Manhattan dismissed a lawsuit alleging that an ETF provider did not warn investors

It takes a brave company to launch an inverse or leveraged exchange-traded fund. The products attracted severe criticism following the 2008 financial crisis and have been the subject of a number of multimillion dollar lawsuits and regulatory fines in the US over the past couple of years.

They were even accused by a Federal Reserve economist in August of contributing to market volatility during the financial crisis and European sovereign debt crisis in 2011.

But for the founders of Boost ETP, a UK-based boutique ETF provider that has launched 36 such products since starting up two years ago, leveraged and inverse ETFs have been unfairly maligned.

“The products have done exactly what they said they were going to do,” says Nik Bienkowski, co-chief executive and co-founder of Boost. “Five or six years on, the products are still the same but the information and education supporting them is much better.”

Leveraged and inverse ETFs are sophisticated products that were designed as short-term trading instruments, rather than for use by buy-and-hold investors. Leveraged ETFs make use of derivatives and debt to provide professional investors with returns of up to three times an index, but they can also deliver up to three times the losses.

Inverse ETFs, meanwhile, are designed to move in the opposite direction to an index. These can also make use of leverage to amplify the gains or losses. Professional investors often use them for just a few days at a time to bet on a particular movement in the market.

But the problems emerged for these products when not-so-sophisticated investors piled into them, buoyed by the promises of three times the returns of traditional passive products. Many of these investors held on for too long and watched in horror during the financial crisis as their expected magnified gains turned into magnified losses.

The problem became more acute thanks to the requirement for these products to be rebalanced daily, meaning that the underlying assets need to be bought and sold to ensure the funds replicate the corresponding index. The result is that the products do not perform well during periods of choppy markets.

“The 2007-9 period was the worst time for these products to launch as it was so volatile,” says Mr Bienkowski. “These are not the best funds to buy during volatile periods, unless you are checking on them frequently. But that’s when they were launched in the US.”

Over the past few years there have been a number of US lawsuits and actions by regulators where investors claim they were not given enough information about how these products would perform and how they should be managed.

In May last year, the Financial Industry Regulatory Authority fined Wells Fargo, Citigroup, Morgan Stanley and UBS a total of $7.3m for allegedly marketing leveraged ETFs to small investors without proper due diligence. The brokerages were also ordered to pay a total of $1.8m in restitution to investors.

Also in May, brokerage RBC Capital Markets agreed to reimburse Massachusetts investors up to $2.9m and paid a $250,000 fine to state regulators for selling leveraged ETFs to inappropriate investors and failing to train and supervise sales staff. That was followed in September by the federal court of Manhattan dismissing a class-action lawsuit against specialist ETF provider ProShares after thousands of investors alleged the provider did not include warnings about the products being inappropriate for most retail investors and did not outline the risks of holding the products for longer than a day.

In May this year, Direxion, another ETF specialist, settled a similar $8m class action lawsuit. Direxion did not, however, admit any wrongdoing in the settlement.

Andy O’Rourke, managing director and chief marketing officer at Direxion, says: “The court cases are behind us. There was never a court ruling against the products. Certainly some people are realising that these products aren’t for them. Other people can move forward knowing that.”

While the providers of inverse and leveraged ETFs feel the reputation of their products has been unfairly damaged as a result of the legal cases, they have responded with more prominent educational drives.

Boost provides factsheets and other educational material about the products on its website to be used by financial advisers if their clients ask about them.

Meanwhile, Direxion has an online course on its website that takes 45 minutes to complete and offers an introduction to the funds.

“We have never had any interest in seeing anyone use them who should not be investing in them,” adds Mr O’Rourke. “If they do not understand them, almost certainly they will have a bad time and are more likely not to use them again.”

Domenick Pugliese, a partner in the corporate practice of Paul Hastings, adds: “The sponsors of these products have done a pretty good job of describing in their prospectuses the pros and risks of the products. The prospectuses are clear.”

Owen Walker is managing editor of Ignites, a Financial Times publication about the US mutual fund industry

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