• U.S. regulators have warned about leveraged funds' complexity
  • Widening market swings in 2011 brought record failure rate

Exchange-traded funds are more popular than ever in the stock market. Even more popular are those using leverage.

In a year where ETF launches are running toward an annual record, funds that employ leverage have almost quadrupled. They’re the ones designed to pay owners some multiple of the gauges they track, usually two or three times the daily return. U.S. regulators have urged caution in the past because of the products’ complexity, warning that amplifying gains and losses can work against investors during extreme swings.

“Investors who don’t fully understand how they trade and function can get hurt,” said Todd Rosenbluth, director of ETF and mutual-fund research at S&P Capital IQ. “There’s the possibility for higher rewards but the likelihood of losing more money if the market swings in the opposite direction.”

More than 190 ETFs have started this year in the U.S. to invest in stocks, a rate that already exceeds any full year since the annual peak of 212 recorded in 2007, data compiled by Bloomberg show. A fifth are leveraged funds, the highest proportion in five years. Firms from ProShares to UBS AG to Direxion have started 39 such funds, surpassing the total in the previous three years, the data show.

The boom has been buoyed by a market that has seen consistent gains with few interruptions since 2011. The Standard & Poor’s 500 Index spent the first seven months this year trading in the tightest range ever. With volatility picking up as an August selloff sent the benchmark index to a correction, concern is growing that investors are falling back in love with these ETFs at the wrong time. The last time the market posted a 10 percent retreat, leverage funds suffered record liquidations the following year.

Leveraged ETFs focusing on health-care account for three of the seven new funds whose assets have exceeded $20 million. The Direxion Daily S&P Biotech Bull 3X Shares has lured more than $130 million since its May launch and two others, Proshares UltraPro Nasdaq Biotechnology and Direxion Daily S&P Biotech Bear 3X Shares, attracted $49 million and $26 million, respectively.

Health-care stocks led the market for five years up till the August selloff, which pulled biotechnology shares into a bear market.

Magnified Effect

Leveraged ETFs have come in for criticism for exacerbating market volatility. Most of the products are reset at the end of each day to align their prices with underlying indexes through buying and selling in futures and derivatives markets that some critics say create artificial pressure on underlying stocks.

In addition, the magnified effect of double or triple leverage may result in divergence in the underlying index over the long term.

In 2009, investors who used the Direxion Shares Financial Bear 3X Shares ETF to bet financial shares would decline lost more than 70 percent of their money in the first four months of the year--even as their prediction came true.

That year, the U.S. Securities and Exchange Commission and Financial Industry Regulatory Authority published an investor alert imploring individual investors to make sure they understood leveraged and inverse ETFs before purchasing one. Laurence Fink, chief executive officer of BlackRock Inc., the world’s largest money manager, said last year that the products are a structural problem and have the potential to “blow up” the industry.

“These geared ETFs are not for mom-and-pop investors. They’re for savvy and knowledgeable investors,” said Michael L. Sapir, chief executive officer of Bethesda, Maryland-based ProShare Advisors LLC. “Unless you fully understand an investment, you shouldn’t buy it.”

Directional Bets

While volatility threatens to erode funds’ ability to deliver targeted returns, it also emboldens speculators who see these leveraged securities as a better use for hedges or directional bets on stocks, according to Bloomberg Intelligence analyst Eric Balchunas.

“Leveraged ETFs are really the investing equivalent of a power tool,” Balchunas said. “This is a great way to get the most juice out of your bet. It’s actually possible for these obscure-sounding products to be big hits.”

After ProShares Short S&P 500 became the first leveraged ETF in 2006, the group’s total assets have expanded to more than $30 billion. While that’s only about 2 percent of the entire equity ETF pool, trading has exploded amid increased popularity among traders, with volume accounting for more than one fifth of all transactions. The $2 billion ProShares Short fund has seen 6.4 billion shares changing hands each day in the past three months, more active than 80 percent of members in the broad equity measure.

Earlier this month in Japan, Nomura Asset Management Co. took the rare step of halting new subscription orders for its Next Funds Nikkei 225 Leveraged Index ETF. Assets under management in the ETF doubled since May, making it the biggest security of its kind in the world even as its price has declined 18 percent.

With the S&P 500’s daily swings widening, cracks are showing up in so-called triple-leveraged ETFs. ProShares UltraPro S&P 500, which moves three times as much as the index, lost 1.9 percent for the year through yesterday even as the market rose 0.3 percent. ProShares UltraPro Short S&P 500, designed to move three times the inverse move, was down 16 percent.

“The leveraged funds do well when the market is trending in one direction without much volatility,” said Michael Rawson, an ETF analyst at Morningstar Inc. in Chicago. “People expect it to provide two or three times the long-term return of an underlying index but if the volatility is really high, it won’t deliver on that,” he said. “We’ve had a pretty volatile year and some of these funds haven’t done as well.”

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