Category Archives: Inverse Funds

Leveraged and inverse exchange-traded funds (ETFs) are getting a bad – and perhaps well deserved – reputation. Critics have coined an endless array of negative descriptors for these products, from “toxic,” to “dangerous,” to “pumped-up investment vehicles with a mountain of risks.”

The characterizations are not without some merit. The Securities and Exchange Commission (SEC), the North American Securities Administrators Association and the Financial Industry Regulatory Authority have issued separate and joint warnings to investors about leveraged and inverse exchange-traded funds. Among their concerns: the growing complexity of the products, their lack of transparency and the potential for investors to experience significant financial losses if they hold onto their funds for more than one trading day.

The first exchange traded fund was launched in 1993. As the products evolved, so did the level of risk. In 2006, ETFs became more aggressive with the introduction of leveraged and inverse exchange-traded funds to the market.

Exchange-traded funds are baskets of investments such as stocks, bonds, commodities, currencies, options, swaps, futures contracts and other derivative instruments that are created to mimic the performance of an underlying index or sector. Leveraged and inverse ETFs, however, are something altogether different. They are not your standard variety of exchange-traded funds.

Leveraged ETFs seek to deliver “multiples” of the performance of the index or benchmark they track. Inverse ETFs do the reverse. They try to deliver the opposite of the performance of the index or benchmark being tracked.

Many investors are under the mistaken belief that a leveraged ETF will give them twice the daily return of the underlying index over the long term. In reality, nothing could be further from the truth.

In recent years, there’s been an increase in arbitration claims and investor lawsuits involving leveraged and inverse exchange-traded funds. The trend is likely to continue in 2012. Moreover, the number of ETFs that have been shut down or liquidated is on the rise, up 500% in each of the past three years over 2007 levels, according to a recent investor alert by the North American Securities Administrators Association. That amounts to one ETF a week.

For investors, these liquidations often prove costly in the form of termination fees, as well as lost opportunity costs if the providers convince investors to stay in the fund through the liquidation process to save on commission costs.

The bottom line: Not all ETFs are the same. While some may be appropriate for long-term holders, others require daily monitoring. The best advice: Know your investment objectives and risk tolerance levels before making the ETF leap.

Synthetic exchange-traded funds (ETFs) have gotten a bad rap lately – and with good reason. Regulators and many financial experts believe that synthetic ETFs are too complex for retail investors and that they may not fully understand the counterparty and derivatives risks they are actually taking on.

Many synthetic exchange-traded funds rely on derivatives to generate returns instead of holding or owning the underlying securities as traditional ETFs do. Synthetic ETFs include inverse and leveraged funds. A leveraged ETF is designed to accelerate returns based on the rate of growth of the index being tracked. For example, if the underlying index moves up 3%, a 2x leveraged ETF would move up by 6%.

An inverse ETF does the opposite. It is designed to perform as the inverse of whatever index or benchmark is being tracked. Inverse ETFs funds work by using short selling, derivatives and other techniques involving leverage.

And with leverage, there always comes risk. As reported Nov. 17 by Investment News, Laurence D. Fink, chief executive officer of BlackRock, Inc., is a staunch critic of some exchange-traded funds. In particular, Fink takes issue with ETFs provided by Societe Generale SA.

“If you buy a Lyxor product, you’re an unsecured creditor of SocGen,” said Fink in the Investment News story. Providers of synthetic ETFs should “tell the investor what they actually are. You’re getting a swap. You’re counterparty to the issuer.”

And therein is the problem.

Counterparty risk means there is a chance that the swap provider could go belly up, leaving investors out in the cold. Remember Lehman Brothers? Following Lehman’s collapse in 2008, many investors quickly discovered that their investments were essentially worthless.

What’s wrong with inverse or leveraged exchange-traded funds (ETFs)? Plenty, if you don’t fully understand how the products actually work or the risks involved.

Inverse or leveraged exchange-traded funds are considered synthetic funds, and they are complicated products that often entail much more risk than traditional ETFs. Leveraged ETFs use “borrowed” money in the form of swaps or derivatives to double or triple the daily returns on a stated index. Inverse ETFs do the opposite. Instead of tracking the fund to the performance of an index, the price of an inverse ETF moves in a direction opposite to the daily movement of its index.

In the past year, synthetic funds have come under growing scrutiny by regulators over concerns that investors may not be aware of the risks that the products pose. Earlier this summer, the Financial Industry Regulatory Authority (FINRA) issued a regulatory notice on leveraged and inverse ETFs. Among other things, FINRA said that the complexity of inverse and leveraged ETFs made them unsuitable for any retail investor who planned to hold on to them for longer than one trading session.

Unfortunately, many investors failed to heed FINRA’s warning because their advisors never thoroughly explained the fine print associated with leveraged and inverse exchange-traded funds. Instead, investors held their investments for much longer periods of time, only to see returns that were vastly different from what they were promised by their financial advisers. This particular scenario has become more frequent over the past year as volatility in the financial markets made performance surprises in the ETF market the norm rather than the exception.

The bottom line: If you’re thinking about investing in leveraged or inverse exchange-traded funds, think long and hard before taking action.

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.