Adviser Investments Fund Update: Vanguard Cuts Leveraged ETFs

Vanguard Cuts Leveraged ETFs From Brokerage

February 7, 2019

Vanguard Says ‘No Leveraged ETFs for You!’ | ‘XXX ETFs’ Ban Effective January 22

Is it appropriate for a brokerage platform to ban certain products to protect investors from themselves? In Vanguard’s estimation, a broad category of exchange-traded funds (ETFs) has crossed that line.

The Malvern, Pa.-based fund colossus recently announced that its clients would no longer be allowed to buy leveraged or inverse ETFs on its brokerage system. The ban went into effect on January 22.

These investment vehicles, also known as “XXX ETFs” or “geared funds,” use complex financial instruments in attempting to double and triple the performance of a given index over a specified period—most commonly every trading day. “Leveraged” ETFs provide multiplied exposure (the “2x” or “3x” you’ll see in fund names) to a benchmark—when the S&P 500 is up 2.5%, a 2x ETF should rise 5.0%. But the reverse is true as well—if the index declines 2.5%, the ETF investor would expect to see a 5.0% loss. “Inverse” funds offer “short” exposure (-1x or -2x), profiting when the benchmark declines on a certain day.

Leveraged ETFs are rebalanced at the end of each period (every day, in most cases). This means that, even when the fund is consistently meeting its goal (returning 2x its index every day), the underlying investment value for any investor who keeps money in the fund for longer periods can swing wildly around the underlying index’s moves. For example, if you put $100 into that 2x ETF and it gains 10% on day 1, the value of your investment would be $120 (an investment in the underlying index would be worth $110). If it falls that same 10% on day 2, the value of your investment would drop to $96, less than where you started. True, the index would have fallen to $99, but the leverage amplifies the losses and creates a larger gap for investors to leap to be made whole.

Vanguard’s stated rationale is that the products’ “extremely short-term, speculative nature is contrary to the long-term focus shared by most investors” and they are “incompatible with a buy-and-hold strategy.”

That’s tough to argue with. In our special report, The ETF Advantage, we include a chart showing the best and worst performing ETFs in 2018. Leveraged ETFs make up the bulk of each side almost exclusively, with some posting 150% annual gains and others near 100% declines. A majority of investors would be happier avoiding these strategies.

We’re not the only ones who’ve noticed how volatile leveraged ETFs can be. In 2015, former Securities and Exchange Commission Chair Mary Jo White spearheaded an effort to ban triple-leveraged funds that relied on derivatives, arguing that they carried too much risk.

She had a point. We believe that leveraged ETFs are indeed dangerous in the hands of those investors who see the potential for eye-popping gains but fail to understand how these vehicles work. In our experience, these types of products are not a good component of a long-term portfolio, and people who invest in them should be prepared for a complete loss. They are also more expensive than the typical ETF—if used as intended and traded frequently, commission fees can add up, and they have the potential to generate taxable short-term capital gains, creating headaches at tax time.

But even we can’t deny that robust demand exists for the products. And regulators have backed off: The SEC’s ban effort came to naught when President Trump appointed Jay Clayton to succeed White. Indeed, in 2017, the oversight committee approved a 4x ETF that aims to quadruple the returns of the S&P 500 on any given day.

Given the SEC’s newly relaxed approach to the funds, Vanguard’s decision to refuse their customers access to something they want to invest in (not to mention kissing the commissions on trades for these products goodbye) seems strange. Plenty of other ETFs are traded rather than bought and held, and the decision-makers in Malvern know this. In terms of danger to investors, the risks of their Extended Duration Treasury ETF (symbol: EDV) or the various incarnations of the recently renamed gold fund, Global Capital Cycles (VGPMX), are comparable to those of leveraged ETFs—though day-to-day volatility may not be as severe.

The leverage ban seems at odds with the trumpeted move last year that made 1,800 Vanguard ETFs free to trade, an implicit appeal to frequent traders, not buy-and-holders. (This did not include any leveraged ETFs, however.)

In the end, the fund titan must expect to lose such a small amount of business in banning leveraged ETFs that it’s just not worth the headache to allow them. At the same time, it gives them an investor-friendly talking point for their marketing campaigns even as they limit choice on their platform.

As of January 22, any investor holding leveraged or inverse investments at Vanguard was welcome to hang on to them. But they’ll need to go through another financial institution to buy more. Investors in such products can also transfer them “in kind” (meaning move them as-is and avoid a potentially taxable transaction) to a different brokerage platform.

Adviser Investments First-Quarter Outlook: Lower Prices, Better Values—Where We See Opportunity for Investors

On January 23, in our live quarterly update, Lower Prices, Better Values—Where We See Opportunity for Investors, we shared our firm’s views on the markets and expectations for the months ahead. Vice President Liz Kesselman moderated a wide-ranging and informative discussion with members of our investment and research teams, led by Chairman Dan Wiener and Director of Research Jeff DeMaso.

If you missed the event or would just like the chance to watch it again, we’ve posted a replay on our website, which you can view at your convenience by clicking here.

The Adviser You Can Talk To Podcast: 5 Financial Planning Resolutions for the New Year

With the new year in full swing, it’s not too late to think about new year’s resolutions—and we’ve got some useful tips to help you focus on your financial health in 2019.

In the latest episode of The Adviser You Can Talk To Podcast, “5 Financial Planning Resolutions for the New Year,” financial planners Victor Colella and Andrew Busa join Vice President Josh Jones to detail five easy steps you can take today.

Click here to listen to “5 Financial Planning Resolutions for the New Year” now.

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