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.