April 29, 2010

Do Leveraged ETFs still make sense?

As reported by Marketwire earlier this week, Rydex|SGI will close 12 leveraged and inverse Exchange Traded Funds (ETFs). Investors gave a clear thumbs down on some of the more obscure ETFs recently which resulted in lackluster demand.  Below is a closer look at the list - good riddance...

Exchange Traded Fund Ticker Net Assets Exp. Ratio
Rydex 2x Russell 2000© ETF RRY 27.46M 0.70%
Rydex 2x S&P MidCap 400 ETF RMM 20.01M 0.71%
Rydex Inverse 2x Russell 2000© ETF RRZ 13.47M 0.71%
Rydex Inverse 2x S&P MidCap 400 ETF RMS 3.75M 0.71%
Rydex 2x S&P Select Sector Energy ETF REA 11.41M 0.70%
Rydex 2x S&P Select Sector Financial ETF RFL 22.13M 0.71%
Rydex 2x S&P Select Sector Health Care ETF RHM 3.57M 0.71%
Rydex 2x S&P Select Sector Technology ETF RTG 8.12M 0.71%
Rydex Inverse 2x Select Sector Energy ETF REC 1.25M 0.70%
Rydex Inverse 2x Select Sector Financial ETF RFN 8.02M 0.70%
Rydex Inverse 2x Select Sector Health Care ETF RHO 1.52M 0.70%
Rydex Inverse 2x Select Sector Technology ETF RTW 1.72M 0.71%

With regard to leveraged and inverse ETFs, we have been expressing our concerns in numerous articles: here; here; here and here, to list a few. Suffice it to say that the more complex ETFs are to be treated with extreme caution and are not ideally suited for average investors. 

While the demand side of leveraged ETFs may be fading, there may be another reason why ETF sponsors are putting a lid on the supply side.  As a result of increased public pressure and greater investor awareness, the US regulator FINRA has issued new margin requirements for leveraged ETFs which will go into effect on April 30, 2010.  FINRA Notice 09-65 details these new requirements. 

Essentially, a 2x leveraged ETF would require twice the normal margin requirement and also increased maintenance margin requirements.  In practical terms, this counterbalances the increased leverage and makes the rationale for purchasing a leveraged ETF highly questionable.  In this case, investors are much better off trading the non-leveraged ETFs which typically have much lower expense ratios.  While this is bad news for day traders (btw. they should really be trading futures if they like leverage), it’s a step in the right direction in terms of bringing excessive leverage into check.   

On a related note, we refer to an article What happens when an ETF closes.  If you are faced with such an announcement, the best course of action would be to sell your shares as soon as the announcement is made.

To find out more about ETFs that are in danger of being closed, please consider Ron Rowland’s ETF Deathwatch.

The number of exchange-traded products (ETPs) on ETF Deathwatch grew again this month.  For April, the quantity is 108 (76 ETFs and 32 ETNs), up from 104 for March.

It will be interesting to see how many of these ETFs on Deathwatch will survive the coming months after investors begin to realize the effects of the new imposed margin requirements. 

P.S.  Limiting the exposure towards market risk is a good thing, particularly for average investors.  In terms of the securities industry, the relatively high margin requirements for buying stocks, generally set at 50%, has been a well established mechanism to reign in some of the more excessive speculative investor urges.  To put these margin requirements in place or to raise them if and when needed is a relatively simple regulatory process, all things considered. 

Why on earth are there no tougher “margin requirements” for purchasing property?  Buying a house with a 5% down payment is basically like trading futures.  While house prices do not fluctuate as rapidly as commodities and other futures prices, they do fluctuate as we all witnessed in the past few years.  Limiting someone’s leverage is the primary tool for risk management and should be imposed on “novice” investors such as home buyers.  Currently, the margin requirement for buying a gold futures contract is about 5.8%.  The minimum down payment for a home mortgage loan through the FHA program is still only 3.5%. Curious...

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