Category Archives: Exchange Traded Funds (ETFs)

Exchange-traded funds (ETFs) have exploded in popularity over the years, but they also come with a number of potential drawbacks. Earlier this summer, the North American Securities Administrators Association (NASAA) expressed concern in an advisory notice that many investors may not fully understand the hidden risks associated with ETFs or how the investments actually work – until it’s too late.

“As with any investment, investors should know what they are investing in. They should understand the risks, costs and tax consequences before investing in ETFs. Check under the hood,” said NASAA President and North Carolina Deputy Securities Administrator David Massey in a June 27 ETF notice.

Exchange-traded funds started in 1993 when State Street sponsored the first ETF in the form of the SPDR Trust. The investments – which are designed to mimic the performance of an underlying index or sector – can be characterized as baskets of investments, and include stocks, bonds, commodities, currencies, options, swaps, futures contracts and other derivative instruments.

The problem is that all ETFs are not created equal. Some traditional ETFs may be appropriate for long-term investors, but other ETFs, such as exotic leveraged and inverse ETFs, may require daily monitoring, notes NASAA in its June ETF notice.

Other risks associated with some ETFs include liquidity. Does the value of the ETF equal that of its underlying securities? The number of ETFs that have been shut down or liquidated is up 500% in each of the last three years over 2007 levels. That comes to one ETF every week.

Huge fees are another issue investors need to be aware of when it comes to some exchange-traded funds. For example, leveraged and inverse ETFs must be traded all the time; that means you will pay a commission or fee each time a share is bought or sold.

The bottom line: The complexity, potential risks and substantial fees of exchange-traded funds may make them unsuitable investments for some investors.

Sales of specialized exchange-traded funds (ETFs) are on the rise. And so is the risk, including liquidity concerns, hidden costs, and overall structure.

Despite these issues, many investors have become enamored with ETFs – and, in particular, inverse and leveraged ETFs – on the advice of their broker. Inverse ETFs are constructed by using derivatives that, in turn, create a security. This security then profits from a decline in the underlying index or benchmark.

This year, inverse and leveraged ETFs became the subject of scrutiny from the North American Securities Administrators Association, which placed the products on its watch list of “investor traps.”

Similarly, the Securities and Exchange Commission (SEC) and the Financial Industry Regulatory Authority (FINRA) have both issued notices to investors about the risks associated with leveraged and inverse ETFs.

Leveraged and inverse ETFs typically are designed to achieve their stated performance objectives on a daily basis. Some investors, however, might invest in these ETFs with the expectation they may meet their stated daily performance objectives over the long term, as well. What many investors fail to realize is that the performance of leveraged and inverse ETFs over a period longer than one day can differ significantly from the stated daily performance objectives of the products.

Concerns about the suitability of leveraged, inverse exchange-traded funds (ETFs) for individual investors may cause Morningstar to stop its 1-to-5 rating of the products. The company may remove the ETFs from broader fund categories altogether and instead place them in a separate group, according to a Sept. 20 story in Bloomberg.

The reason for the possible change is that the ratings are designed for investment vehicles, and leveraged ETFs are trading vehicles. The products use derivatives and debt to amplify the returns of a market index, while inverse funds profit from declines in an underlying benchmark.

In an effort to determine whether investors needed additional protections regarding leveraged ETFs, the Securities and Exchange Commission (SEC) stopped approving new ETFs that made significant use of derivatives in March. Several months later, both the SEC and the Financial Industry Regulatory Authority (FINRA) issued a notice to investors on leveraged ETFs.

Among other things, the regulators cautioned investors about the products and stated that they may be inappropriate for long-term investors because returns can potentially deviate from underlying indexes when held for longer than a trading day.

Private placement offerings and leveraged ETFs (exchange-traded funds) are among the investments that con artists turn to as a way to scam innocent victims. Private placements in particular have been in the news lately, with their issuers – i.e. Medical Capital Holdings and Provident Royalties – accused of committing fraud.

As reported April 9 by CNBC, it’s become increasingly commonplace for investors to find themselves a victim of an investment scam or con. According to the North American Securities Administrator Association (NASAA), senior citizens are the No. 1 target for fraud, with baby boomers ranking a close second. In 2008, the FBI estimated that some $40 billion was lost to securities and commodities fraud.

In addition to private placement offerings, leveraged ETFs rank high in terms of potential abuse for fraud. While legitimate financial products, ETFs are complicated investments that trade on a daily basis. ETFs use exotic financial instruments, including derivatives, to generate better returns than the market return. This potential volatility, along with the increased exposure to risk, may make ETFs an unsuitable investment for most retail investors.

The best way to prevent fraud is to do your homework. If you suspect a deal is too good to be true, contact your state securities regulator. You also can find out if the person selling the offering or investment is registered with the Financial Industry Regulatory Authority (FINRA) on FINRA’s BrokerCheck Web site.

Another red flag to be aware of: Guarantees of a high rate of return on unregistered securities.

Leveraged and inverse ETFs have found themselves under the regulatory microscope recently, which makes it all the more interesting that ProShares has decided to launch eight new exchange-traded funds that aim to magnify their benchmark exposures by 300%. The story was first reported Feb. 12 by Investment News. 

Leveraged and inverse ETFs try to achieve a return that is a “multiple” of the inverse performance of the underlying index. For Proshares’ new series of ETFs, that means the funds seek a +300% or -300% return of their indices for a single day before fees and expenses. 

In the summer of 2009, several investors initiated lawsuits and arbitration claims involving the Ultra ProShares Funds and UltraShort ProShares Funds. Specifically, investors accuse ProShares of issuing “false and misleading registration statements, prospectuses and additional information” in connection to the funds. As a result of the alleged false promotion of the products, many investors suffered enormous losses. 

In June, the Financial Industry Regulatory Authority (FINRA) issued a statement on leveraged and inverse ETFs, reminding broker/dealers that the products “typically were unsuitable for retail investors” who hold them longer than a single day. FINRA later restated its position, saying that member firms could recommend leveraged and inverse ETFs to retail investors provided that the broker/dealer conducted a suitability assessment of the investor and the ETF itself. 

Massachusetts Secretary of State William Galvin also has taken up the issue of leveraged and inverse ETFs. In July 2009, Galvin began an investigation of the sales materials of companies that sold the funds. The state later sent letter to three ETF leaders – ProShares, Direxion Funds and Rydex Investments. 

The bottom line: Leveraged and inverse ETFs are not for everyone. These types of ETFs provide leverage on a daily basis. Above all, leveraged and inverse ETFs are not a save-and-hold investment – a fact that many retail investors were woefully unaware of. 

The controversy surrounding leveraged exchange traded funds (ETFs) shows no sign of letting up, and on Sept. 1, the Financial Industry Regulatory Authority (FINRA) announced plans to raise margin requirements for leveraged ETFs beginning Dec 1. FINRA’s Regulatory Notice 09-53 states that the “inherent volatility” of leveraged ETFs is one of the reasons for the new requirements.

The change in regulations comes on the heels of a lawsuit filed by a group of investors in August against ProShares and one of its leveraged inverse ETFs. The investors allege that ProShares misrepresented the UltraShort Financials ProShares Fund and that they were never informed shares in the fund should not be held for more than one single trading day.

Leveraged ETFs are considered a subset of traditional ETFs and attempt to generate multiples (i.e. 200%, 300% or greater) of the performance of the underlying index or benchmark they track. Some leveraged ETFs are “inverse” funds, which means they try to deliver the opposite of the performance of the index or benchmark they track. Leveraged ETFs can include among their holdings high-risk derivative instruments such as options, futures or swaps.

The complexity and potential risks associated with leveraged ETFs have garnered both the media spotlight and the attention of regulators who contend many retail investors do not fully understand how the products work. Both FINRA and the Securities and Exchange Commission (SEC) recently issued warnings highlighting the risks for investors in leveraged ETFs, particularly those who invest for the long term. In response, some brokerage firms announced new sales limits on client investments in leveraged ETFs, while others halted sales altogether.

In July, Massachusetts’ Secretary of State William Galvin launched an inquiry into how three leveraged ETF providers – Rydex, ProShares and Direxion – marketed and sold leveraged ETFs, as well as what they were telling brokers who sold the funds to clients. Detractors of leveraged ETFs, including FINRA and the Securities and Exchange Commission (SEC), contend retail investors may not fully understand the complexity of ETFs nor realize the products must be monitored on a daily or near daily basis.

Three years ago, there were no leveraged ETFs in existence. Today, there are more than 140 leveraged ETFs with about $30 billion in assets.

Leveraged and inverse exchange-traded funds (ETFs) have come under fire recently for the potential dangers these complex financial products may hold for individual investors. ETFs are designed to capture two or three times the movement in a particular stock index or, in the case of an inverse ETF, provide results that are 100% opposite. In the current economic climate, however, many investors are discovering huge distortions in the stated performance objectives of these investments.

The Securities and Exchange Commission (SEC) and the Financial Industry Regulatory Authority (FINRA) both issued investor alerts recently on leveraged and inverse ETFs, cautioning individuals about the investing pitfalls these highly specialized and complex products can create.

Specifically, leveraged and inverse ETFs provide leverage on a daily basis. Many investors fail to understand this concept and, instead, wind up buying an ETF and holding it for a year, which can put them at a huge financial risk.

In a recent SEC alert, two real-life examples were depicted of how returns on a leveraged or inverse ETF over longer periods of time can be widely different from the performance (or inverse of the performance) of their underlying index or benchmark during the same period of time.

Example 1: Between December 1, 2008, and April 30, 2009, a particular index gained 2%. However, a leveraged ETF seeking to deliver twice that index’s daily return fell by 6% – and an inverse ETF seeking to deliver twice the inverse of the index’s daily return fell by 25%.

Example 2: During that same period, an ETF seeking to deliver three times the daily return of a different index fell 53%, while the underlying index actually gained around 8%. An ETF seeking to deliver three times the inverse of the index’s daily return declined by 90% over the same period.

The SEC’s advice to individual investors who may be considering a leveraged or inverse ETF is to thoroughly do their homework. Make sure to understand the ETF’s stated objectives, as well as its potential risks. It’s also important to know that leveraged or inverse ETFs may be more costly in terms of fees than traditional ETFs. FINRA’s Fund Analyzer can estimate the impact of fees and expenses on your investment.

In addition, there can be significant tax consequences associated with leveraged or inverse ETFs that are less tax-efficient than traditional ETFs.

In the face of regulatory inquiries and pronouncements by the Financial Industry Regulatory Authority (FINRA) on the inherent risks they pose to retail investors, more brokerages are curtailing their activity in leveraged and inverse exchange traded funds (ETFs).

FINRA initially raised questions about inverse and leveraged ETFs when it issued a notice to brokers/dealers on June 11, cautioning them that the instruments may not be suitable investments for retail investors who plan to hold onto the instruments for more than one trading session.

Shortly after FINRA’s edict, Saint-Louis based Edward D. Jones announced its intent to halt sales of leveraged ETFs. UBS and Ameriprise soon followed. Other brokerages, including Charles Schwab, Raymond James Financial and LPL Financial are reviewing their policies concerning ETFs, with some firms posting information on their respective Web sites that inverse and leveraged ETFs “are not right for everyone.”

Leveraged ETFs allow investors to amplify bets on a wide range of markets, while inverse ETFs make profits when prices fall.

Many investors, however, are unaware about the complexities and underlying risks of inverse and leveraged ETFs. Leveraged ETFs, for example, are designed to deliver their stated leverage on a daily basis. If an investor holds the ETF longer than one trading session, it potentially could lead to financial disaster. Leveraged ETFs also employ, as their name implies, leverage. This, in turn, increases the level of financial risk for investors.

On August 5, a lawsuit involving ETFs was filed in New York, accusing ProShare Advisors LLC and others of violating a securities act by failing to disclose the risks of its ProShares UltraShort Real Estate fund (SRS). Among the risks that the complaint contends the inverse leveraged exchange traded fund failed to cite: “Spectacular tracking error.”

Specifically, the lawsuit alleges that the fund’s index fell 39.2% from January 2008 to December 2008, but the fund fell 48.2%, which was not in accordance with ProShares’ stated objective that UltraShort ETFs go up when markets go down.

The complaint is seeking class-action status, according to an Aug. 6 article in the Wall Street Journal.

The dramatic losses of the SRS fund reiterate the inherent risks posed by inverse and leveraged ETFs, especially in times of a volatile market. In the 12 months through July 23, the Dow Jones U.S. Real Estate Index shed 38%, but the ProShares UltraShort Real Estate fund lost 82%, according to the Wall Street Journal article. This year through July 23, the index is down 3.5%, but the fund has slipped 67%.

The devil is in the details. This is especially true for leveraged and inverse exchanged traded funds, or ETFs. These aggressive and complicated financial products have evolved from straightforward instruments to funds that use baskets of derivatives and risky credit swaps to provide inverse, leveraged, leveraged-inverse, and commodity-linked returns. Unlike traditional ETFs, inverse and leverage ETFs have “leverage” inherently embodied into their product design. Translation: Increased risks for investors.

Leveraged ETFs use credit swaps or derivatives to amplify daily index returns, while inverse ETFs are designed to profit from a decline in the value of the underlying assets that the fund mirrors. This could be a stock index, currency, commodity or specific industry sector like real estate. If the underlying index declines by 1%, the inverse ETF should, in theory, increase 1% on that same trading day.

Investing in leveraged and inverse ETFs can be tricky, not to mention potentially dangerous for the average investor. These types of ETFs are meant to reflect the underlying asset moves on a daily basis. When held longer for a day, the end result can spell financial disaster.

Leveraged and inverse ETFs are big business for investment firms and financial advisers. Assets in leveraged and inverse funds increased 51% this year, reaching $32.8 billion. This explosive growth prompted the Financial Industry Regulatory Authority (FINRA) to issue a warning to brokers in June that leveraged and inverse ETFs may not be an appropriate investment for long-term investors because returns can deviate from underlying indexes if held for longer than a day.

Since then, several investment firms have halted their sales of leveraged ETFs. Among them: UBS, Edward Jones and Ameriprise Financial.

Yesterday, a class-action lawsuit was filed against ProShares – one of the top sellers of inverse and leveraged ETFs – over one of its inverse leveraged exchange traded funds. According to the complaint, the ProShares UltraShort Real Estate fund did not disclose a series of risks associated with the fund, including a “spectacular tracking error.” The lawsuit also says the company markets its leveraged funds as “simple directional plays.”

The ProShares UltraShort Real Estate fund was designed to deliver amplified returns against an index, which in its case was the Dow Jones Real Estate Index. The returns were supposed to be twice the opposite of that index. In 2008, however, the index fell 39%, yet the fund fell 48%.