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Yes, Leveraged And Inverse ETPs Belong In Client Portfolios

FEBRUARY 22, 2017 RON DELEGGE

Look at the top and bottom performing exchange-traded products for any given year. And
what youll discover is funds that short the market or utilize leverage will invariably be atop
the list of both best and worst performers. For instance, the top three best performing
ETPs so far this year are the VelocityShares 3x Inverse Natural Gas ETN (DGAZ), Direxion
Daily Jr Gold Miners Bull 3X ETF (JNUG), and the ProShares UltraShort Bloomberg Natural
Gas ETF (KOLD).

Meanwhile, the bottom performersjust like the top performersall use leverage or
inverse exposure and are the VelocityShares 3x Inverse Crude Oil ETN (DWTI), VelocityShares
3x Long Natural Gas ETN (UGAZ) and the Direxion Daily Jr Gold Miners Bear 3X ETF (JDST).

Within the nancial services industry there seems to be a total lack of understanding in how
leveraged and inverse performing products are to be used. (Inverse exchange-traded funds
and exchange-traded notes are also sometimes referred to as short funds because they
move in the opposite direction of their underlying benchmark.)

For example, Morgan Stanley Smith Barney recently shelled out $8 million in settlement
costs related to inverse ETFs. Other brokerage rms have faced similar nes related to the
usage of short and leveraged funds. According to the SEC, Morgan Stanley failed to
adequately implement policies and procedures to ensure that clients understood the risks
involved with buying inverse ETFs.

Because of litigation, some brokerage rms have taken radical steps to totally ban advisors
associated with their rms from using ETFs that employ leverage or aim to deliver inverse
performance. Rather than making a concerted e ort to educate nancial advisors about the
proper time and place for these types of sophisticated ETFs, certain brokerage rms have
overreacted by taking a hyper-cautionary approach.

How can advisors and the rms they work for avoid being reactionary when dealing with
funds that go short or use leverage?

A better approach, I believe, is to have a rm-wide educational program that teaches

advisors to understand that leveraged and short ETFs have a highly restricted role which is
exclusively limited to a clients non-core investment portfolio. The non-core bucket is always
much smaller in size verus the clients core portfolio. Likewise, the non-core portfolio is
solely reserved for higher-risk strategies that can involve multiple strategies that go beyond
merely shorting or using leverage to magnify performance.

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Incidentally, my strategy for segregating investment assets into core and non-core portfolios
was laid out in an earlier article published here at ETF Advisor titled The Core Points of ETF
Portfolio Construction. In that piece, I provided a rigid framework for assembling an
investment portfolio that helps investment clients to reach their goals while simultaneously
keeping nancial advisors out of trouble.

The idea that highly geared ETFs should be avoided or banned from the nancial
marketplace couldnt be more wrong. And I wholly reject this dogmatic view or any other
opinion that promotes the misinformed viewpoint that leveraged and short funds require
special treatment or additional regulatory oversight. And Im not alone.

In a comment letter about ETFs that use leverage and inverse funds, Georgetown University
nance professor James Angel wrote, While leveraged and inverse ETFs often have risk
levels comparable to individual stocks, banning 2x and 3x ETFs is a bad idea." He added, If
the SEC is concerned about protecting investors, it will focus on the degree to which
investors understand the risks they are taking on, rather than trying to ratchet down all risk.

The bottom line is that ETFs which employ leverage or short the market arent a problem.
The real issue is the misapplication of these products by advisors and investors. And its a
problem that can only be solved by keeping these sophisticated ETF products exactly where
they belong: in an investors non-core bucket. Putting them anywhere else is almost
guaranteed to cause a boatload of trouble.

Ron DeLegge is founder and chief portfolio strategist at ETFguide.

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