The ETFs seek to provide 200% or -100% of the return of the KBW Regional Banking Index for a single day, before fees and expenses.  The KBW Regional Banking Index, the most widely used benchmark for U.S. regional banking stocks, was created and is managed by KBW.

Before today, those seeking leveraged exposure to inverse and leveraged ETFs have usually relied on the crazy triple-leverage ETFs from Direxion: the Direxion Daily Financial Bull 3X Shares (NYSE: FAS) and the Direxion Daily Financial Bear 3X Shares (NYSE: FAZ) hae seen an increase in volume of late.

There is also the Ultra Financials ProShares (NYSE: UYG) is meant to track the daily move of the twice the daily performance of the Dow Jones U.S. Financials index; and the Short Financials ProShares (NYSE: SEF)  is mean to track the daily investment results of the inverse of the daily performance of the Dow Jones U.S. Financials index.  Now you have leverage, and you have it in regional banks.

There is more and more competition on the leverage and inverse ETF front.  Whether these are winners or losers compared to peers and competitors, that will be seen through time.  As with all leverage and inverse ETF or ETN products, caveat emptor!  These are all prone to index tracking errors.

JON C. OGG

While this is not against any single leveraged ETF (or inverse ETF), it may have at least some influence on leveraged ETF and reverse-leveraged ETFs.  The two key ETFs for leverage and high volume and high volatility are the Direxion Daily Financial Bull 3X Shares (NYSE: FAS) and the Direxion Daily Financial Bear 3X Shares (NYSE: FAZ) as they are the triple-leverage financial sector ETFs.

A handful of the other active leveraged and inverse-leverage ETFSs are as follows: Ultra Financials ProShares (NYSE: UYG) seeks twice the daily performance of the Dow Jones U.S. Financials index.  UltraShort Financials ProShares (NYSE: SKF) seeks twice the inverse of the daily performance of the Dow Jones U.S. Financials index. UltraShort S&P500 ProShares (NYSE: SDS) seeks twice the inverse of the daily performance of the S&P 500 Index. Ultra S&P500 ProShares (NYSE: SSO) twice the daily performance of the S&P 500 Index.

Before you go out and worry too much about how many warnings are out there, the industry itself has been making more warnings of its own.  Direxion was either the first or one of the first to come out with a detailed analysis of how its ETFs have performed differently than the target index through time.  They have even engaged in a reverse stock split to curb some of the volume and volatility that is inherent with such low-priced stocks.  Direxion even warned how these are not to be held by long-term investors, so our own take on this is they have gone above and beyond their duty of warnings on how these act.

John Gannon, FINRA Senior Vice President for Investor Education: “Not all ETFs are created equal… leveraged and inverse ETFs can deviate substantially from the performance of the underlying benchmark…. that can turn into a minefield for buy-and-hold investors.”

The FINRA/SEC warning reminds investors that leveraged and inverse ETFs “pursue a range of investment strategies through the use of swaps, futures contracts and other derivative instruments.” It also notes that most leveraged and inverse ETFs reset daily as they strive to achieve the gain or loss performance on a daily basis.

The FINRA/SEC warnings also used the Direxion example of how the returns have differed through time.  The warning advises investors to consider these products only if they are confident the product can help meet their investment objectives and they are knowledgeable about and comfortable with the risks associated with these specialized ETFs.

In short, there is nothing different now about these products for active traders and day traders.  There is just a much deeper understanding by the public that 3X return goals might not generate a real 3X return through time.

JON C. OGG
August 19, 2009

This morning came an announcement from Morgan Stanley Smith Barney that it has placed certain restrictions on the sale of leveraged, inverse, and leveraged inverse exchange traded funds.  The reason even started out as “In response to concerns raised by regulators about these securities…”

The firm has noted that as of today, solicited purchases of these products will not be permitted in traditional brokerage accounts. Furthermore, it noted that unsolicited purchases in these accounts will be permitted only subject to enhanced oversight and review.  Lastly, the firm has noted that no purchases of these securities will be permitted in advisory accounts managed by Morgan Stanley Smith Barney Financial Advisors.

Morgan Stanley Smith Barney went on to note that Financial Advisors have also been encouraged to review existing positions in these securities with clients to emphasize their unique characteristics and risks.

We placed a call into the firm to see if this had become a large portion of the brokerage business in trading volumes, but the standard “we would not disclose that data” was all we got from the media relations.  It is hard to imagine that brokers and advisors of the firm would be actively pushing these leveraged and inverse-leverage ETFs to their clients regularly.  In fact, our take on this is that this is more of a “CYA” statement for internal purposes.  After all, this does not create an outright ban on these products.

What is interesting is that at least some of the managers of these ETFs have been vocal about the risks and have even demonstrated how through time these will not necessarily correlate to the exact or expected returns of the underlying indexes.  Direxion, in our opinion, gave one of the best disclosures that an ETF manager could give.  It said in a formal filing, “Particularly in periods of heightened volatility, the ETFs should be used by investors as short-term trading vehicles. As a consequence, we do not believe that investors should buy and hold the funds.”

With the inquiry from Massachusetts already out in the world of leveraged ETF products, we would expect more firms out there to adopt similar internal regulations or restrictions.  And the overall impact or effect it may have, that is probably minimal.

JON C. OGG
AUGUST 7, 2009

Ultra Financials ProShares (NYSE: UYG) seeks twice the daily performance of the Dow Jones U.S. Financials index.  UltraShort Financials ProShares (NYSE: SKF) seeks twice the inverse of the daily performance of the Dow Jones U.S. Financials index. UltraShort S&P500 ProShares (NYSE: SDS) seeks twice the inverse of the daily performance of the S&P 500 index. Ultra S&P500 ProShares (NYSE: SSO) twice the daily performance of the S&P 500 index.

There are many other issues from leveraged ETF families out there.  These are just some of the top leveraged exchange traded funds by trading volume.  But there are some considerations here that are a part of the Mass. Secretary of State inquiry.

As we noted before, Direxion specifically addressed several focal issues.  It has shown how returns differ from the target index and even went as far as saying these are not suitable investments for long-term investments.

We have confirmed with Direxion that Secretary Galvin has made an inquiry, but our contact also noted that the firm is cooperating with the inquiry and is very comfortable with all of their practices.  More specific details from the office of the Secretary of State have not been given to us as of yet.

What Secretary Galvin is probably looking to make sure of is that investors know what they are getting into, and that these funds are not being held by many widow and orphan funds.

We have essentially zero reason to expect any closure of these ETFs over this inquiry.  Nor do we expect these issues to have any bearing over the operations of these leveraged ETFs.  If anything, the inquiry would seem to lead to even more disclosure practices, and in the most extreme case it could possible create some ‘suitability issues’ that could make these exclusionary for certain types of investors and/or for certain retirement funds.

You can always join our open email distribution list to stay on top of key developments for ETFs and leveraged-ETFs, as well as keeping up with issues on key daily analyst calls, IPO’s, mergers, and other key events.

Update… CNBC has an interview with Secretary Galvin on this matter.
JON C. OGG
July 15, 2009

Direxion just announced a reverse split for another ETF yesterday, but not its two financial triple-leverage ETFs.  Direxion Daily Financial Bull 3X Shares (NYSE: FAS) is now back down close to $8.00 per share, yet it trades 250 million shares on an average day.  The Direxion Daily Financial Bear 3X Shares (NYSE: FAZ) is barely above $5.00 and trades more than 200 million shares on an average day.  So between the FAS and FAZ, you have an average of more than 450 million shares, and at today’s prices that is close to $3 billion worth of nominal value.

This review discusses a portion of the ETFs and ETNs and the ones under discussion today, along with underlying key companies, are Ultra Financials ProShares (NYSE: UYG), Bank of America Corporation (NYSE: BAC), B2B Internet HOLDRs (AMEX: BHH), Ariba, Inc. (NASDAQ: ARBA), Internet Capital Group (NASDAQ: ICGE), Internet Infrastructure HOLDRs (AMEX: IIH), VeriSign Inc. (NASDAQ: VRSN), Akamai Technologies Inc. (NASDAQ: AKAM), United States Natural Gas (NYSE: UNG), United States Oil (NYSE: USO), SPDR Gold Shares (NYSE: GLD), UltraShort S&P500 ProShares (NYSE: SDS), SPDRs (NYSE: SPY), New York Stock Exchange (NYSE: NYX) and the NASDAQ OMX Group Inc. (NASDAQ: NDAQ).

Ultra ETFs…

Ultra Financials ProShares (NYSE: UYG) is another low-priced active ETF.  Its seeks twice the daily performance of the Dow Jones U.S. Financials index, and normally invests 80% of the fund’s assets in financial instruments with economic characteristics that should be twice the return of the index.  With a trading range of $1.37 to $25.03 over the last year, it is easy to see where the volatility can go.  This trades nearly 100 million shares on average, yet its price is $3.65 after a 2.5% gain.

Merrill Lynch HOLDRs

Now that Bank of America Corporation (NYSE: BAC) owns Merrill Lynch, it is time for it to clean house on at least two of the HOLDRs family of ETFs.  HOLDRs are hybrd ETFs that gave investors a chance to individually own shares directly in underlying stocks. Based on how much direct mail was sent out just a year or two ago on the Semiconductor HOLDRs, B of A could save everyone some serious money by not having to send out that proxy and annual report material to holders of each stock. Let alone a headache.

The B2B Internet HOLDRs (AMEX: BHH) is an old legacy ETF that should just go away.  While it trades over 30,000 shares on average, it is deep into penny-stock territory.  Now that its last major constituent was acquired, Ariba, Inc. (NASDAQ: ARBA) and Internet Capital Group (NASDAQ: ICGE) are the only two holdings left.  Maybe this is just for pairs trading on days when Ariba has big news.

Internet Infrastructure HOLDRs (AMEX: IIH) is another one of the old legacy ETFs from the Internet Bubble days that went from active and high priced to micro-cap and generally thin volume.  Of course the 266,000 shares around noon is a slap in the face against the argument today, but this frequently sees less than 10,000 shares.  The page for the weighting also has over 82% of the entire ETF weighting as being only two stocks: VeriSign Inc. (NASDAQ: VRSN) with 55.76% and Akamai Technologies Inc. (NASDAQ: AKAM) having 27.9%.

ETFs and ETNs in Commodities….

There are two funds which track energy commodity prices, and these ETFs have actually been accused of manipulating the price of underlying commodities.  Jim Cramer recently blasted the United States Natural Gas (NYSE: UNG) fund.  He said this one has actually become large enough because it gave traders a chance to buy big enough quantity of natural gas that he thinks the fun ran up prices because it invests almost entirely in near-month natural gas futures contracts.  If that gets $100 million in buy orders for the ETF, that goes directly into the natural gas futures market.

A similar situation was noted earlier this year and last year during the oil boom and bust: the United States Oil (NYSE: USO) ETF is meant to track the spot price of West Texas Intermediate light sweet crude oil.  Yet during the boom and bust of oil, futures traders were able to game the “USO” because of its order flows and high demand followed by an exodus.  Whether or not this one is responsible for running up or running down the commodity is something that will never be proven.  How many speculators told Congress that speculators were not responsible for the run-up in crude last year?  Sometimes the answers are obvious, but are not easy to quantify.

And the beloved gold ETF the SPDR Gold Shares (NYSE: GLD) has good intentions too.  But it goes out and purchases direct bullion and exchange baskets.  This ETF is so large that it is still said to be among the top 10 holders in entire gold reserves.

In commodities, it would seem that FINRA might consider making some of these trade as closed-end funds with limits to size in relation to the entire market of the underlying commodity.  That is not likely to occur, but it is a thought.  If inflation ever gets too heated, don’t be too shocked if and when you see a sudden Congressional press or or a FINRA-led press to stop inflows from making the commodity prices move solely be ETF owners buying more and more.

Two S&P ETFs That Do Work…

The UltraShort S&P500 ProShares (NYSE: SDS) against the SPDRs (NYSE: SPY) is an example of a pair of an inverse ETF and corresponding long ETF that actually work the way these were meant to work.  The SDS trades 45 million shares on average and that is over $2 billion worth of nominal value.  It is technically twice the inverse performance of the S&P 500 Index.  The “Spies” trade about 275 million shares a day, yet the price is nearly $90.00 (one-tenth of S&P).  That is over $24 billion worth of stock in nominal value.  Compare this dollar volume daily to that of the FAS and FAZ.

Other Issues to Consider

There is another notion here to consider, and that is the New York Stock Exchange (NYSE: NYX) and the NASDAQ OMX Group Inc. (NASDAQ: NDAQ).  Both major exchanges have relaxed the old absolute guidelines on the $1.00 rule.  There are many stocks that fell under $1.00 that are just too active in trading volume.  Booting those funds off the exchange because of the numbers of stocks they own and because of the number of shares would be the exchanges intentionally cutting off some of their own trading volume business.  How many operating businesses want to intentionally choke their own business and income streams?  Yep, not many.

It is impossible to say whether or not a reverse split would make a huge difference in the volatility of low-priced ETFs.  You could even make a case that if the prices were adjusted higher via a reverse stock split that the underlying ETFs would see more volatile price moves as each penny is worth less and less on a percentage basis.  For a $5.00 stock, each penny up or down is 0.20% and that is before any commissions are applied.

There are other risks here if ETFs are allowed to grow indefinitely.  Imagine if the entire world decided to trade ETFs rather than ever invest in individual stocks.  This would make the money flows of an ETF determine the direction of a stock.  Imagine if a company was small and attractive, but was not part of any ETF.  That company would be public, yet effectively shut out of the market.

This list of questionable ETF and ETN investment is actually far longer than just these mentioned today.  We will be following up with each of these individually over the next week or two by fund family and/or by asset class.  You can also learn more about these via subscribing to our open email distribution list.

Jon C. Ogg
June 23, 2009

The PowerShares Financial Preferred (NYSE: PGF) is the ETF that specifically tracks the preferred shares of financial stocks.  This can also be impacted, although we would note that this ETF here has five of its top ten holdings which are European bank preferred shares and the top ten holdings are over half of the ETF.

This comes on the hells of this morning’s Bank of America Corporation (NYSE: BAC) announcement that it was offering a tender exchange offer on nine of its preferred series for up to 200 million shares of common stock.  At today’s prices, that would represent more than $2.2 billion in new common stock.  The largest US bank holding company issuers we have seen with Bank of America are JPMorgan Chase & Co. (NYSE: JPM), Wells Fargo & Co. (NYSE: WFC), and Goldman Sachs Group Inc. (NYSE: GS).

We have already seen some selective retirement of preferred stock from the likes of Citigroup, Inc. (NYSE: C), and that accomplished some of the same issues that Bank of America was trying to address.

All of these index levels actually track just the common stock, so the dilution, the new issuances, and the potentially larger market caps of the common shares would be what matters to these ETF’s.  These ETF’s are only full of the common stocks.

The biggest issue out there for how this will affect the ETF’s which track banks, financials, and preferred shares is the overall weighting.  If B of A is successful at this, we could easily see other banks following suit.  JPMorgan CEO Jamie Dimon already bought preferred shares.

The incentive here is actually rather simple to retire these at lower prices than the traditional $25.00 PAR if possible.  The yields on many of these preferred securities is close to 10%.  Some yields are even higher.  Bankers cannot make that much spread even if the credit card rules were not changing.

There is also the notion that these preferred share redemptions act as effective Tier-1 capital raising activities.  Some consider this a balance sheet trick, but if it lowers current obligations and long-term debt then that is ultimately good for shareholders of common stock in today’s environment even if you consider the dilution that the common holders have to accept.

JON C. OGG
May 28, 2009