By: DWH Legal
Leveraged exchange traded funds (“ETFs”) were first introduced in 2006, and 3x Leveraged ETFs – designed to achieve 3x the performance of the underlying index or benchmark that a particular ETF tracks – were first introduced in November 2008 in the midst of the global financial crisis.
Unlike traditional ETFs, such as SPDR S&P 500 ETF, 3x Leveraged are risky, short-term trading vehicles that are not meant to be held as long-term investments. Many 3x Leveraged ETFs, such as (NUGT) and (DUST), routinely lose 20% or more in a single day and last month a 3x Long Brazil ETF (BRZU) set a record by declining -48.3% in a single day.
Importantly, almost all 3x Leveraged ETFs “reset” daily – meaning they are designed to achieve their stated objective of 3x return on a daily basis. Due to the effects of compounding and the costs associated with the daily re-set, the performance of 3x Leveraged ETFs quickly diverges from the performance of the underlying index or benchmark to the negative in a phenomenon known as “decay” or “levered fund decay.” This process is accelerated the more volatile the underlying index or benchmark are.
FINRA, in a Regulatory Notice issued in June 2009 — only seven months after the introduction of 3x Leveraged ETFs – noted the decay phenomenon and cited an instance where a 3x Leveraged ETF tracking the Russell 1000 Financial Services Index fell 53% while the index itself gained around 8 percent over a seven month time period. FINRA also reminded firms of their suitability obligations with respect to leveraged ETFs, and noted that, “leveraged ETFs typically are not suitable for retail investors who plan to hold them for more than one trading session [day], particularly in volatile markets.”
Despite FINRA’s strong warnings, many firms and advisers have placed their clients into Leveraged ETFs for extended time periods. Just last month, FINRA suspended an Oppenheimer broker for six months based on the fact the broker’s customer held positions in Leveraged ETFs for as long as 470 days and for an average of 40 days. Thus, it is critically important that investors be specifically counseled that 3x Leveraged ETFs are short-term trading vehicles meant to be held for a day and not long-term investments. Failure to do so will expose firms to significant regulatory risk, and to potential claims from investors who suffer losses in 3x Leveraged ETFs.
If you are an investor who has concerns about investments made in 3x Leveraged ETFs or an investment adviser or broker-dealer professional who has questions regarding 3x Leveraged ETFs, please contact us.
 See In the Matter of Edward T. McFarlane, FINRA Letter of Acceptance, Waiver and Consent No. 2016050393901 (May 18, 2017).