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Court rejects appeal over leveraged funds' volatility

By Jonathan Stempel

NEW YORK (Reuters) - In a decision that reminds investors about the potential dangers of leverage, a federal appeals court on Monday rejected a lawsuit challenging how risks were disclosed by a group of exchange-traded funds that aimed to magnify market movements.

The 2nd U.S. Circuit Court of Appeals said ProShares Advisors LLC was not liable to investors who claimed they were misled about the risks of holding on to 44 of its leveraged ETFs for more than one day.

Among these risks is that ETFs could cause losses even if investors bet correctly on the direction of particular markets.

Monday's decision upheld a September 2012 ruling by U.S. District Judge John Koeltl in New York.

Christopher Lovell, a partner at Lovell Stewart Halebian Jacobson representing the investors, did not immediately respond to requests for comment.

Leveraged ETFs use derivatives and debt to amplify short-term returns. They are designed for short-term investors who target outsized gains and can stomach large losses if a market moves against them.

ProShares, one of the largest providers of the product, offered ETFs designed to double, move inversely to, or double the inverse performance of an underlying index or benchmark on a daily basis.

Thus, if an index rose 2 percent on a given day, then these ETFs would be expected to respectively rise 4 percent, fall 2 percent and fall 4 percent. Leveraged inverse funds are also known as "ultra short" funds.

Investors contended that between August 2006 and June 2009, a period covering the global financial crisis and a plunge in stock prices, ProShares failed to disclose the risks that its ETFs might post substantial losses, and knew it could happen even if investors bet correctly on a market's direction.

They cited as an example a three-month period when a U.S. bank stock index fell 22.84 percent. They said a ProShares ETF meant to double that index's inverse performance might have been expected to gain 45.68 percent, but instead fell 17.3 percent.

Circuit Judge Richard Wesley, however, wrote for the 2nd Circuit that ProShares had disclosed the "speculative" nature of the ETFs in prospectuses, and that the ETFs might move "quite different from and even contrary to" what investors expect.

"No reasonable investor could read these prospectuses without realizing that volatility, combined with leveraging, subjected that investment to a great risk of long-term loss as market volatility increased," Wesley wrote.

In 2009, the U.S. Securities and Exchange Commission issued an alert that advised buy-and-hold investors about the "extra risks" posed by leveraged and inverse ETFs. (http://www.sec.gov/investor/pubs/leveragedetfs-alert.htm)

"ProShares clearly and comprehensively disclosed the risks of investing in their ETFs in a volatile market," said Robert Skinner, a partner at Ropes & Gray, in an interview. "The plaintiffs' bar has tried to take advantage of the financial crisis in these lawsuits, but courts have recognized that all of the relevant risks were fully disclosed."

Skinner also represented fund distributor SEI Investments Distribution Co, another defendant.

The case is In re: ProShares Trust Securities Litigation, 2nd U.S. Circuit Court of Appeals, No. 12-3981.

(Reporting by Jonathan Stempel; Editing by Steve Orlofsky and Kenneth Barry)

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