Leveraged ETFs Might Go to Court

Leveraged exchange-traded-funds (ETFs) have caught the attention of regulators, and now law firms have noticed the products as well.

One law firm announced a class action lawsuit against ProShares (a unit of ProShare Advisors LLC), and another law firm is investigating the sale of leveraged ETFs at several broker/dealer firms.

Monday, the law offices of Howard G. Smith announced that a class action lawsuit has been filed on behalf of people who purchased or otherwise acquired shares in the UltraShort Real Estate ProShares fund (the SRS Fund; ticker: SRS), an ETF offered by ProShares Trust (ProShares). The firm said the law suit is on behalf of people who acquired the shares traceable to ProShares’ “false and misleading Registration Statement, Prospectuses, and Statements of Additional Information … issued in connection with the SRS Fund’s shares.”

According to the law firm, ProShares sells its Ultra and UltraShort ETFs as simple directional plays. Meaning, ProShares Ultra ETFs are designed to go up when markets go up and UltraShort ETFs are designed to go up when markets go down.

The SRS Fund is one of ProShares’ UltraShort ETFs and seeks investment results that correspond to twice the inverse (–200%) daily performance of the Dow Jones U.S. Real Estate Index. The law firm contends that based on the performance of real estate sector, the SRS Fund should have appreciated by 78.4% in 2008. Instead, the SRS Fund fell 48.2%—“the antithesis of a directional play,” the law firm said.

The complaint alleges the defendants violated the Securities Act by failing to disclose that the SRS Fund is altogether defective as a directional investment play. It also says that ProShares failed to disclose all of the risks, such as: the severe consequences of high market volatility on the SRS Fund’s investment objective and performance, and the rarity of an inverse correlation between the SRS Fund and the DJREI over time.

Law Firm Looks at Broker/Dealers

It’s not just investment managers who could face legal brouhahas: Broker/dealers might also be facing lawsuits for the sale of the instruments.

The securities law firm of Dimond Kaplan & Rothstein, P.A., announced earlier this month that it is investigating claims involving investment losses in leveraged and short ETFs. The law firm cited these broker/dealers as having sold ETFs: Merrill Lynch, Wells Fargo Advisors (formerly Wachovia Securities), Smith Barney, LPL Financial, Ameriprise, Edwards Jones, UBS, and Morgan Stanley Smith Barney.

The law firm said investors are often not informed of the true risks of using leveraged and short ETFs, which can carry a high risk to an investor’s principal. “ETFs have been recommended to investors seeking both safe investments and longer-term investing,” the firm said. “And as a result, many investors have unknowingly taken on unsuitable risk of loss and have suffered unexpected losses in ETFs.”

The firm mentioned three firms as prominent providers of the most widely sold ETFs: Rydex Investments, Direxion Funds, and ProShares.

Some broker/dealers have already responding to the increased scrutiny about some ETFs by restricting or banning the sale of such instruments (see “MSSB Bans Leveraged ETF Sales” and “Edward Jones Puts Brakes on Leveraged ETFs”).

Regulators have been vocal about the risk associated with the products. The Financial Industry Regulatory Authority (FINRA) has called leveraged ETFs typically unsuitable for long-term investors.