Recently, I’ve posted two entries about exchange traded funds.  One was a general overview of ETFs, the other discussed gold ETFs.  Today, I want to dig into the topic area a little more deeply by looking at Proshares and a controversy that continues to rage in the ETF world.

Proshares is one of the five largest providers of ETFs in the United States.  They currently offer 92 different exchange traded funds.  But these aren’t your run-of-the-mill funds.  Proshares specializes in inverse and leveraged ETFs.  These funds are assembled with the goal of outperforming the index to which they’re tied and are often based on shorting.

Let’s say you thought frozen concentrated orange juice was going to drop today.  You could buy into one an short-based, or inverse, ETF.  If frozen concentrated orange juice dipped 5%, you’d theoretically post a gain of approximately 10% (that’s the leveraged part).  And, of course, the Duke Brothers would be very upset.

Proshares is really focused on funds of these sorts and has marketed them fairly aggressively.  Unfortunately, not everyone really thinks they’ve been entirely above-board in their efforts.  That’s where the controversy comes into play.

Gilman and Pastor, LLC, is a law firm that is pursuing a class action lawsuit against Proshares, alleging that the company is selling defective security product.  The firm states:

ProShares touted its UltraShort ETFs including those listed above, as simple-to-execute investments which go up when markets go down. Although ProShares touts its securities and cloaks them with certainty due to allegedly reliable mathematical formulas, their math does not add up.

They go on to argue that the math Proshares is using is only good for a single day and that anyone holding these investments for more than one day can’t expect the kind of leveraged performance Proshares touts.  They maintain that Proshares marketing was deceptive and that the company failed to provide adequate information to investors about these “extremely confusing products.”  You can read the whole complaint here, and it does make an interesting and rather compelling case that leveraged ETFs should only be considered day trading tools.

Another law firm, Zamansky and Associates, is also hot on the heels of Proshares.  They have a long list of complaints about the nature of the funds and the way those funds are marketed and allege (among other things) that Proshares:

* Failed to disclose the long term risks and inverse relationship between the funds’ and indexes
* The negative consequences of market volatility
* The negative effects of the funds’ daily adjustments
* That leverage ETF’s are unsuitable investments

I’ve been close enough to law firms and those who populate them to approach some of these claims and the motivations behind class action lawsuits more than a little bit.  I’m not saying that these firms are right or that they’re wrong about Proshares.  I just want to make it clear that I don’t necessarily think they’re pure-hearted white knights.

In any case, Proshares has weighed in on this controversy, too.  In an open letter published at their website they discuss whether they’re leveraged ETFs are really just quick-hitters for the day-trading crowd or a credible investment strategy.  On a “facts and fallacies” page, they take on many of the other claims levied against them.

I don’t know how the legal issues will play out, but I’d be willing to bet on my overall perspective regarding leveraged and inverse funds like those at the heart of the controversy.  They’re probably not a smart toy to put into the hands of novices.  They’re inherently more risky than traditional plays–anything that promises twice the potential return comes with twice the risk.  It makes sense to do just what Proshares recommends, which is to check them as often as daily to see if you need to rebalance.