Are leveraged and inverse exchange-traded funds worth the risk?
As investors flock to the stock market and the ETF industry in this period of historically low interest rates, issuers are hoping buyers do their homework before jumping into some of these complex strategies.
Leveraged and inverse ETFs both use financial derivatives in their underlying constructs. Leveraged ETFs use derivatives and debt to multiply the returns of their underlying indexes, tracking the stocks on a 2-to-1 basis rather than the standard 1-to-1, for example. Inverse ETFs are meant for those looking to profit from an index's decline.
Both types of ETFs tend to reset their holdings daily, however, which indicates that they were built more for day traders than long-term investors, David Mazza, head of product at Direxion, told CNBC's "ETF Edge" on Monday.
"As a provider of leveraged and inverse ETFs, we want to ensure that folks are using them appropriately and correctly. And they're really intended to be for traders or folks that have the ability and potential to pay keen attention to their portfolios," he said. "For investors who use them appropriately, many of them can find them to be helpful ... as some part of their overall strategy. But they're not intended to be long-term buy-and-hold investment vehicles."
Late last year, the Securities and Exchange Commission proposed rules that would require leveraged and inverse ETF providers to ask their customers a series of questions to make sure they understood the risk involved in buying these products. Issuers pushed back, saying it could crush that corner of the market.
Lately, calls to re-regulate or re-categorize these types of funds have become amplified in the ETF community, causing more intense scrutiny around these vehicles.
Tom Lydon, CEO of ETF Trends and ETF Database, acknowledged that these funds are "not play toys."
"They are an integral part of the ETF ecosystem, and this recent campaign was not put out by the SEC. It's put out by other ETF issuers who don't have a dog in the hunt," Lydon said in the same "ETF Edge" interview.
"So, is it really for the benefit of the investors? Possibly. Is it also a competitive move? That might be it, too. But the horse has definitely left the barn here," he said. "Investors, if they want to shoot themselves in the foot, probably are not going to turn to ETFs. They're probably going to go to the futures or the options market or penny stocks or something like that."
At the end of the day, investors' gut checks shouldn't come from regulators, Mazza and Lydon agreed.
"Whether it's two times or three times performance, what's going to cause that performance up or down is what's in the basket. So, we strongly encourage everyone to understand that ... more so if you're going to be tactical with it, more so if you're going to look to trade it for a shorter-term opportunity," Mazza said.
"I do think it makes sense for investors to be informed, and we want to continue to educate folks on that, but trying to bifurcate an already confused matter ... would almost confuse investors more if we end up with even more categories than there are," he said.
Lydon also sided with issuers, warning that a greater degree of regulation could threaten the ETF industry on the whole.
"If all of a sudden you want to buy an inverse [or] leveraged ETF and you go in your Charles Schwab account and you try and buy it and a skull and crossbones shows up, is that really good for the industry when most people are doing their homework?" Lydon said.
"I think what we have to do is look at everything as a whole," he said. "And we're going to continue to have educational barriers that will be out there, but do we want to throw all these types of ETFs — not just including inverse and leveraged, but others that might have futures contracts or might have options overlays and things like that — all into one bucket and say, 'These are more sophisticated?' Really not sure. I think this is one thing we're going to continue to talk about, and that's the great thing about the industry. It's very democratic."