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Financial Advisors Under Fire

The debate over leveraged and inverse ETFs has been getting a bit heated recently. Here is the worry: federal regulators are concerned that financial advisors are not adequately explaining to the public what these ETFs do--and don't do.

Financial advisors are now concerned they may have left themselves open to potential lawsuits. Several have already decided not to offer them, and all of them will be tightening their language.

The problem: tracking error. Leveraged ETFs are designed to give you leverage, say 200 percent of the return on an index, like the S&P 500. So if the index goes up 10 percent in a day, you make 20 percent. Inverse ETFs are the opposite: say, 200 percent of the inverse of the index, so if the index goes up 10 percent in a day, you lose 20 percent, and vice-versa.

But because these ETFs reset at the end of each day, there is the potential for significant tracking error from the underlying index.

Here's an easy example.

Say on Day 1, you buy an ETF that gives you 200 percent of the daily return of an index. Say this index is at 100 at the start of the day, and it goes up 10 percent, so it closes at 110.

Your 200 percent ETF will go up twice as much, so the ETF goes up 20 percent, from 100 to 120.

Congratulations.

You made money.

Now it's Day 2. The underlying index goes DOWN 10 percent, so it goes from 110 to 99.

Your two-day return on the index: minus 1 percent.

But look at the 200 percent ETF. It goes DOWN twice as much, so it's down 20 percent. It goes from 120 to 96. Your two-day return: down 4 percent.

Wait a minute!

The index is down 1 percent, so you would think your 200 percent ETF would be down twice as much, or 2 percent. But it's not: it's down 4 percent.

This mismatch is called tracking error, and it can get worse--or better--as time goes on. The tracking error can be especially acute during times of heavy volatility, where the markets go up and down.

There will likely be less tracking error when the market has been moving more smoothly in one direction or another.

One example: the S&P 500 is up 10 percent year to date. ProShares Ultra S&P 500 (SSO), which is designed to give you twice the DAILY return of the S&P 500, is up only 15.5 percent, well short of the 20 percent gain you might expect (twice the return).

However, if you look on a shorter term--one month, where the market has been mostly going up, the S&P is up 8 percent, the Ultra is up 16 percent, exactly what you would expect--twice the return.

So does this mean individual investors should not use these inverse and leveraged ETFs, or not for more than one day? The Financial Industry Regulatory Authority (FINRA) last week clarified their guidance on this by saying "Leveraged and inverse ETFs can be appropriate if recommended as part of a sophisticated trading strategy that will be closely monitored by a financial professional. At times, this trading strategy might require a leveraged or inverse ETF to be held longer than one day."

The bottom line is that you need to understand what these instruments are; they may end up being used largely by sophisticated, active investors.

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