Exchange Traded Funds (ETFs) are usually investment companies that offer shares representing a fractional interest in a group of securities that tracks an underlying benchmark or index. The shares of an ETF trade throughout the day on a securities exchange at a price driven by the market. While ETFs typically trade in stocks, they can also invest in commodities or currencies, though these particular ETFs are not usually registered as investment companies
Besides the basic type, there are leveraged ETFs, inverse ETFs and leveraged-inverse ETFs.
Like basic ETFs, the leveraged and inverse types may track broad indices, or be sector-specific, or be linked to commodities or currencies. Inverse ETFs are often marketed as a way to profit from a falling market or as a hedge against a falling market.
These leveraged, inverse and leveraged-inverse ETFs are highly risky. Investors should be aware that many brokers may not fully understand the risks, characteristics and goals of these securities even they recommend them.
The goal of a leveraged ETF is to end the day a certain multiple higher than the index or benchmark it tracks.
The goal of an inverse ETF is to end the day with a result that is the inverse of the index or benchmark it tracks. For this reason an inverse ETF is also called a short fund.
The goal of a leveraged-inverse ETF is a return that is a multiple of the inverse of the performance of the underlying index. For example, an inverse ETF might track a particular index and aim for a result that is the inverse of the index performance, while a 2x-leveraged-inverse ETF aims to deliver double the inverse of the index’s performance. A leveraged-inverse ETF may also be called an ultra short fund.
ETFs in the leveraged and inverse categories might use such investment strategies as futures contracts, swaps, and other derivative products.
Investors need to be aware that these products are designed to achieve their goals on a daily basis, and that there is always the risk that an ETF will fail to meet its objective on any given trading day.
According to the Financial Industry Regulatory Authority (FINRA), these products can be used effectively within sophisticated trading strategies, but they are often unsuitable for those who typically hold their investments for longer than one session.
Compounding can affect the results of an ETF over time, meaning the result might end up far removed from the originally stated goal that was based on a single trading session, FINRA says. Because of this, leveraged, inverse and leveraged-inverse ETFs designed to reset daily are not often suitable for retail investors who plan to hold them for longer than one trading day, especially when markets are volatile.
FINRA also notes that leveraged, inverse and leveraged-inverse ETFs are often more expensive the basic ETFs.
An investor alert on ETFs issued by FINRA and the Securities and Exchange Commission (SEC) in August 2009 highlights possible long-term/short-term confusion. Some investors might expect ETFs to meet their daily performance goals over the long term as well, the alert said, when in fact the results can diverge dramatically.
To explain these complicated products, FINRA offered some examples to show how an ETF designed to perform at twice the level of a index from the close of trading on the first day to the close of trading on second day won't necessarily achieve that result over longer periods of time.
For example, in the six months ended April 30, 2009, an index gained two percent, but the 2x-leveraged ETF that sought to deliver twice the index's daily return fell by six percent, and an inverse ETF that sought to finish at twice the inverse of the index fell by 26 percent.
In the same six months, a 3x-leveraged ETF fell by 53 percent, while the index on which it was based gained 8 percent, and a 3x-leveraged-inverse ETF based on the same index fell by 90 percent.
FINRA illustrates how this divergence can happen with a hypothetical scenario that assumes an ETF has met its stated goals:
Index = $100 in value
2x-Leveraged ETF = $100 in value.
End of Day 1
Index falls by 10 points = 10 percent loss = $90 ending value
2x-Leveraged ETF falls by 20 points = 20 percent loss = $80 ending value
Index rises 10 percent = $99 ending value
2x-Leveraged ETF rises 20 percent = $96 ending value.
The leveraged ETF met its stated goal of two-times the daily index returns on both the days represented here, but the results reveal that losses have a much greater impact on a leveraged ETF than they do on a straightforward index fund.
As FINRA and the SEC pointed out in their investor alert, the index lost one percent, falling from $ 100 to $ 99, while the 2x-leveraged ETF lost four percent, falling from $100 to $96. Therefore, the negative return of the 2x-leverage ETF was four times as much as the return of the index, instead of two times the return, as it was at the end of Day 1.
Sophisticated parties like institutional investors may develop trading and hedging strategies that could make holding onto a leveraged or inverse ETF sensible, but retail investors with mid-range or long-term goals should be wary. The results can diverge from the performance of the underlying index or benchmark so rapidly that an investor might suffer steep losses even if the underlying index posted a significant long-term gain.
FINRA reminded brokerage firms of their obligations concerning leveraged, inverse and leveraged-inverse ETFs the regulatory notice it issues in June 2009. Recommendations to customers must be suitable and based on a full understanding of the product. Sales materials must be fair and accurate and firms must have adequate supervisory procedures in place to make sure these obligations are met.
In addition, the notice said firms must train their brokers so they thoroughly understand the features and risks of all the ETFs they sell.
The investor alert advised investors to make sure that any investment professional to whom they turn for advice understands their objectives and risk tolerance. The investment professional should also be able to clearly and fully explain how an ETF suits the investor's objectives. They should also be willing to monitor the ETF.
If you have suffered losses as a result of leveraged, inverse or leverage-inverse ETFs recommended by a stockbroker or an investment professional and you were unaware of the risk associated with these securities, you should consult with an attorney to determine whether your losses may be recoverable through FINRA securities arbitration.
Nicholas J. Guiliano, Esquire, Guiliano Law Firm, P.C. Practice limited to the representation of investors in arbitration claims against stockbrokers for fraud, the sale of unsuitable investments, breach of fiduciary duty, failure to supervise. National Practice. Contingent Fee. Free Consultation. (877) SEC-ATTY.