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.