Originally launched in 2006, leveraged ETFs use financial derivatives and debt to magnify the returns of the underlying index they track, sometimes by two or three times for a single day. Inverse ETFs try to achieve the opposite performance, by using derivatives to profit from a decline in the value of an underlying benchmark. The result, for investors in these products, was often huge gains, followed by huge losses.
Not surprisingly, it didn't always go so well. Investors, and even their financial advisors and brokers who sold these products, didn't completely understand their complexity, leaving them unable to properly disclose risks involved. A flurry of lawsuits followed.
(Read more: Emerging markets ETFs: Which to buy, which to avoid)
Just this month, the Financial Industry Regulatory Authority (FINRA) announced that it settled with Stifel and broker affiliates to pay combined fines of $550,000 and close to $475,000 in restitution to 65 customers that were sold leveraged and inverse ETFs from 2009 to 2013. The suit stated that the sellers did not adequately understand these products when recommending them to their clients—the settlement required no admission of guilt.
The key issue that people didn't understand about leveraged and inverse ETFs is that they are designed to "reset" daily, meaning that their performance can quickly deviate from the performance of their underlying index or benchmark. The multiple is the intended leveraged or inverse factor that the fund is aiming for, such as two times or negative one times the index.
"The problem is that funds deliver this multiple for only one day," explained Paul Britt, senior ETF specialist at ETF.com. If investors hold the fund longer than that, then there's no assurance that they will get that multiple. "This does not make the products unusable for periods greater than one day, but investors must rebalance to achieve the multiple for longer periods," Britt said. "If they don't, they can find their returns quickly plummeting, resulting in magnified losses in a volatile market, even while the long-term performance of the index is showing a gain."
Or as Arthur put it: "You still have to be a day trader, very short term, to look at something like the VIX exchange traded portfolio [VXX]."