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SEC-FINRA Warns Investors

by Eric Daugherty

If your Uncle (Sam) is your (Big) Brother, are you better off? And, how much should governent be doing to protect us from ourselves? These questions arose from the joint SEC-FINRA alert regarding leveraged ETFs and sparked debate in our office last week. On the one hand, some of us are anti-government-intervention and pro-free market. Do we really need Uncle Sam (or in this case Uncle Sam AND the industry) playing Big Brother and telling us what is suitable for our portfolio? On the other hand, the last few years have shown us that there is too much complexity and opacity in financial products, and American investors hold too much in their portfolios that they do not understand.

We will certainly continue to see more of a push for transparency in product details, which is needed. Leveraged ETFs are a perfect example of how a seemingly great idea can actually be a wolf in sheep's clothing. In theory, leveraged ETFs may make absolute sense for investors who are willing to expose themselves to magnified gains or losses. If I am 30 years old, rich, smart, good-looking, and charming (hey, if I'm claiming to be age 30, might as well embellish across the board), believe in the market going up over my 50-year investing horizon, and am willing to accept additional risk, why limit myself to an arbitrary 0-100% stock allocation instead of investing in a 2X market portfolio? This was once vein of the argument in our office.

In concept, it made sense. Then we delved a bit deeper. It turns out that we didn't full understand the intricacies involved in these products. Specifically,

• Even over long time horizons, ETF returns can significantly decouple from the benchmark return
• To maintain the leverage ratio, the ETF must buy into rising, and sell into falling, markets
• Almost by definition, they have high transaction costs, leading to high expense ratios See this slightly dated, but readable (and pro-leveraged ETF) article here that does a decent job of laying out the mechanics.

We have blogged before about the need for certain, innovative products. We hold products up to a litmus test that asks:

• Does the investment fit a particular investor need or solve a problem in a compelling manner?
• Is it reasonably low cost?
• Is it simple, transparent, and understandable enough for the average investor?

All three points here are vital: leveraged ETFs can say yes to the first, but not to the remaining two.

It would be ideal if investors and their advisors would do all the due diligence required to evaluate investment products fully, or learned quickly from being burned. Until then, though, expect this new age of oversight and industry/government collaboration to stick around for a while.