Two years ago, Citigroup Inc. (NYSE:C), Morgan Stanley (NYSE:MS), UBS AG (NYSE:UBS) and Wells Fargo & Company (NYSE:WFC) were fined a combined $9.1 million, including $1.8 million in restitution, by the Financial Industry Regulatory Authority (FINRA) for selling leveraged ETFs to investors without adequately explaining how they work and why they are so risky. Now, two financial advisors at California-based Financial Engines think retirees should consider allocating 15% of their portfolios to triple-leveraged ETFs, reports Anna Prior for The Wall Street Journal.
Jason Scott and John Watson argued in an article published by the CFA Institute’s Financial Analysts Journal last year that the ‘floor-leverage rule’ is a good strategy for guaranteeing sustainable spending while giving investors the potential for a major upside by investing 85% of their portfolio in something very safe such as Treasury Inflation Protected Securities (TIPS) and putting the remaining 15% into very high risk triple leveraged ETFs, which aim to deliver three times the underlying index’s daily returns (or its opposite for a 3x bear ETF).
Leveraged ETFs daily returns don’t compound in an intuitive way
Leveraged ETFs are tricky because they magnify daily returns, which don’t compound the way unsophisticated investors might expect them to. Prior gives the example of the Direxion ETF which lost 14.9% in 2011 when the S&P 500 gained 2.1%, and it serves to illustrate why leveraged ETFs are so risky – the daily volatility that buy-and-hold investors don’t need to worry about out can absolutely wreck leveraged ETFs.
Retirees normally want to protect their principal
If this sounds like a bad strategy for most investors, it makes even less sense for retirees because they don’t have any way to replace principal once it has been lost. Retirees with a large portfolio don’t need to take such outsized risks to chase higher returns because of their shorter investment horizon, and retirees who are worried about having enough money saved shouldn’t risk their principal regardless.
Right now, Financial Engines isn’t actually recommending leveraged ETFs to its clients, but Scott says that he is working on products that include them to be sold at some point in the future. No doubt Scott and Watson are acting in good faith here, trying to develop innovative new products for their clients, but considering the trouble that major banks got into (many of which now forbid their advisors from mentioning leveraged ETFs to clients) and the large sums their clients lost, it just seems like a bad idea.