Should Anyone Be Allowed to Buy Leveraged ETFs?

I don’t care to belong to any club that will have me as a member.

The famed comedian Groucho Marx may have been kidding, but would investors feel the same way if they had to go through an approval process to use volatile ETFs? Leveraged funds, including those focused on single stocks, have exploded in number and popularity in recent years. But the products are so potentially dangerous in the wrong hands that Bloomberg’s editorial board suggested this week that brokerages should restrict access to customers who haven’t been vetted, and that strategies should be limited to 2x leverage. The op-ed piece followed disastrous episodes of South Korean leveraged ETFs crashing as chip-maker stocks fell. And it comes as the Securities and Exchange Commission has effectively blocked any new funds aiming to use more than 2x leverage.

“It’s hard to imagine the retail investors that these kinds of products would make any sense for,” said Corey Frayer, director of investor protection at the Consumer Federation of America. “They are at best high volatility gambling. And they are at worst a cash grab for management fees … with the lure of outsized returns.”

The Velvet Rope Approach

Making traders jump through hoops has limitations, as shown by South Korea, Bloomberg’s board  pointed out. Despite needing training courses to gain access, those ETFs have been (or were) popular among investors. Newer restrictions in that country have reportedly driven at least some traders to use US leveraged products. Of course, US traders are a different matter, and the companies that provide such funds disclose that they are intended to be held very short term, generally not across multiple days. 

Even so, financial literacy is low in the US relative to other countries:

• Just 13% of people had high financial literacy, according to results of a recent survey by Allianz that tested investors on their knowledge.
• Meanwhile, 33% had low financial literacy scores.
• In the US, as is the case globally, confidence and competence don’t match up. Over a quarter of US respondents said they were more knowledgeable than the average investor.

“We see this gap between financial confidence and financial competence,” said Simon Krause, an Allianz economist and author of the company’s report, adding that more people have been turning to artificial intelligence for advice, which further inflates their confidence. “That is worrisome.”

Let This Be a Warning: To be fair, issuers are quick to point out that their products should only be used by experienced traders. And it might be a step too far to ban leveraged funds outright, but giving them the equivalent of a flashing red light to alert users of the possible magnified losses would be useful, said Benjamin Schiffrin, director of securities policy for Better Markets. That could also include a point-of-sale message showing how a leveraged fund’s returns can diverge from those of individual stocks. “They’re probably inappropriate for retail investors, but they’re being heavily marketed to retail investors,” he said. “We need to do a better job of regulating to whom they’re sold.”