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.