The Risks of Inverse and Leveraged ETFs

Exchange-Traded Funds (“ETFs”) are a relatively new investment product that may be an appropriate investment depending on an investor’s investment experience, objectives, risk tolerance, and investment time horizon. A new breed of ETFs have appeared in the market place, inverse and leveraged ETFs, that pose significant risks to investors. FINRA and the SEC have issued news releases warning investors and financial advisors about the unique risks and strategies attributable to inverse and leveraged ETFs. Below are excerpts from FINRA’s Investor Alert that further explain the risks:

What Are Exchange-Traded Funds?

ETFs are typically registered investment companies whose shares represent an interest in a portfolio of securities that track an underlying benchmark or index. (Some ETFs that invest in commodities, currencies, or commodity or currency-based instruments are not registered as investment companies.) Unlike traditional mutual funds, shares of ETFs typically trade throughout the day on a securities exchange at prices established by the market. ETFs have evolved over the years, becoming more complex. Investors considering ETFs should evaluate each investment closely and not assume all ETFs are alike. In the last few years, a number of leveraged and inverse ETFs have been introduced to the market that are very different from the traditional variety of ETFs.

What are Leveraged and Inverse ETFs?

Leveraged ETFs seek to deliver multiples of the performance of the index or benchmark they track. Inverse ETFs (also called “short” funds) seek to deliver the opposite of the performance of the index or benchmark they track. Like traditional ETFs, some leveraged and inverse ETFs track broad indices, some are sector-specific, and others are linked to commodities, currencies, or some other benchmark. Inverse ETFs often are marketed as a way for investors to profit from, or at least hedge their exposure to, downward moving markets.

Leveraged inverse ETFs (also known as “ultra short” funds) seek to achieve a return that is a multiple of the inverse performance of the underlying index. An inverse ETF that tracks a particular index, for example, seeks to deliver the inverse of the performance of that index, while a 2x (two times) leveraged inverse ETF seeks to deliver double the opposite of that index’s performance. To accomplish their objectives, leveraged and inverse ETFs pursue a range of investment strategies through the use of swaps, futures contracts, and other derivative instruments.

Most leveraged and inverse ETFs “reset” daily, meaning that they are designed to achieve their stated objectives on a daily basis. Their performance over longer periods of time—over weeks or months or years—can differ significantly from the performance (or inverse of the performance) of their underlying index or benchmark during the same period of time. This effect can be magnified in volatile markets.

Investing in ETFs, like inverse leveraged ETFs, have risks that should be clearly explained to the investor. Just because an account or an individual investment has decreased in value does not necessarily mean that a financial adviser has acted inappropriately. At Crary Buchanan, we provide consultations concerning negligence arising from improper financial advice. We invite you to call us to discuss your rights and remedies under the law.

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