Exchange-traded funds are one of the fastest-growing segments in the financial services industry. And leveraged bull and bear ETFs that promise double or triple exposure to their underlying subindex are growing even faster.

Usually, leveraged ETFs own shares of companies in the underlying subindex and “gear up” performance with over-the-counter derivatives. There are also some more complicated products that track the performance of underlying commodities such as oil.

In the latter cases, the leveraged ETF holds underlying futures contracts, adding another dimension to performance, as the manager rolls contracts over to the next month. How the futures market values the outlook for oil creates some interesting distortions in the value of the ETF.

The real issue, however, is the use of OTC derivatives to create the leverage. This isn’t necessarily bad, but clients need to be educated on the potential risks.

For example, Di-rexion Financial Bear 3X Shares (symbol: FAZ) is a leveraged ETF whose objective is to provide three times the inverse movement of the U.S. financial services sector.

FAZ was initially listed in November 2008. Not surprising, the value of the ETF has declined at a time at which there has been some significant strength in the underlying subindex.

What’s interesting — and, at the same time, disturbing — is the performance of Direxion Financial Bull 3X Shares ETF (symbol: FAS), which purports to give three times leverage on any upside movement in the financial sector subindex.

Given the performance of FAZ during the past six months, one would expect FAS to have done just the opposite; but, in fact, its returns have been highly correlated to FAZ.

You can be excused for asking how two ETFs with mirror-image objectives — and whose values are determined by the performance of the same underlying subindex — can both perform so badly over the same period. The answer lies in how the derivatives that create the leverage are priced.

According to marketing material from Direxion Shares, the aforementioned ETFs hold a basket of financial services stocks and set the leverage through derivatives — likely OTC options contracts that are priced off some offsetting exchange-traded options. When you understand how options are priced, the rational for the performance of the Direxion ETFs becomes apparent.

There are six factors that go into pricing options: the underlying value of the subindex; the strike price of the options; the time remaining to expiration; the risk-free rate of return; dividends paid by companies in the underlying subindex; and volatility. It is the last item that must be estimated — and it has a major impact on the value of the options contract.

Volatility impacts the price of call and put options (the underlying derivatives) in the same way; which is to say, a rise in volatility pushes up the price of both calls and puts while a decline in volatility reduces the value for both calls and puts.

When you think about leveraged ETFs, the bull version is effectively a call option; the bear version is a put option. This means the value of the ETFs has as much to do with changes in volatility as it does with the direction of the underlying subindex.

It appears that the Direxion ETFs are victims of bad timing. The funds were launched in November 2008, when options premiums were at all-time highs. Since then, volatility has declined sharply and, in the process, hampered the performance of both ETFs.

The challenge for the industry and for regulators is how to educate investors about the intricacies of these products while, at the same time, allowing the industry to do what it does best: create solutions that appeal to segments of the investor community.

In the case of leveraged ETFs, investors are buying giant perpetual options contracts. Investors can purchase these instruments in a regular brokerage account and, in some cases, assume they can be used as long-term investments just like other ETFs. However, these ETFs are anything but. IE