Expect a wave of claims this year against financial advisors and broker/dealers who recommended certain Direxion, Rydex and ProFunds leveraged and inverse funds, last year's worst performing mutual funds, say securities attorneys. Leveraged funds, which use derivatives to place big bets on whether an asset price will rise or fall, have been a lightning rod for litigation in recent years. In 2009, suits involving leveraged ETFs represented 6 percent of all new securities lawsuits, according to insurance data firm Advisen.

Regulators have had their eye on leveraaged and inverse funds for a couple of years now, as well. In August of 2009, the Securities and Exchange Commission (SEC) and the Financial Industry Regulatory Authority (FINRA) sent out a warning to broker/dealers that described leveraged and inverse ETFs as “highly complex financial instruments that can turn into a minefield for buy-and-hold investors.” And in May 2010, FINRA raised the margin requirements for leveraged ETFs. Meanwhile, the SEC is currently reviewing all derivatives-based funds, including leveraged and actively managed ETFs, to see what protections might be needed.

According to Morningstar data, the five inverse/leveraged funds in question — two from Direxion, two from ProFunds and one from Rydex — were down between 42 and 51 percent last year (see Table), with three- and five-year negative returns in the double digits as well. Despite the poor performance, the funds experienced significant inflows in 2010. For example, the ProFunds UltraShort Small Cap Fund, which had about $27 million in assets as of December 2010, raked in nearly $15 million last year.

And yet, overall, leveraged mutual funds have been losing assets, with net outflows of $169 million over the past 12 months, and $606 million over the past three years, according to Morningstar. At the end of 2010, total assets in leveraged mutual funds sat at about $1.45 billion. Conversely, assets in leveraged ETFs have been steadily growing, partly because they are so new. Over the past three years, leveraged ETFs have gained $27.6 billion, bringing total assets to $28 billion at the end of 2010.

The problem is, while inverse/leveraged funds are appropriate for some sophisticated investors in small doses, they have been sold more aggressively in some cases. Inverse/leveraged funds are best for institutional or high-net-worth investors who want to hedge exposure and protect against short-term market issues, says David Kathman, senior mutual fund analyst with Morningstar. Allocations should be no more than about 5 percent, he added. “Even then, I would hope they would be cautious because these types of things can turn on a dime.”

But some advisors and broker-dealers have been recommending the inverse/leveraged funds to elderly and retired people in allocations of 10 to 30 percent, said Andrew Stoltmann, an investment attorney with the Stoltmann Law Offices. Stoltmann has been receiving calls about the five mutual funds since the middle of 2010. “There's no question we're going to be filing claims this year,” Stoltmann said. “You're putting a Ferrari in the hands of a 16-year-old in some cases.”

Inverse/leveraged funds have also been sold to investors without proper disclosure of their risks, said Christopher Gray, a New York-based lawyer representing one investor in a claim against his financial advisor and branch manager for financial losses in two ProShares leveraged funds. His client was saving for retirement, and the arbitration claim alleges that the two funds recommended by his financial advisor were excessively risky and unsuitable given his investment objectives.

In recent years, many fund companies have revamped their disclosures to make the dangers of such funds more explicit to investors. ProFund Advisors posted an open letter on its website stating that leveraged and inverse funds are not appropriate for every investor. The first page of Direxion's prospectus points out that these funds are riskier than funds that don't use leverage and are not for every investor. Rydex's prospectus outlines similar risks.

But prospectus and website disclosures are not enough, said Alan Sparer, an attorney with Sparer Law Group. Advisors should also send letters to clients in clear language, he says, and keep documented notes of conversations with clients about risk disclosure. Sparer is currently handling a class action suit against Rydex, which claims the firm didn't adequately disclose the compounding effect of an inverse fund. In July 2009, Rydex changed its registration statement to include such a disclosure.