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ETFs: Look Beneath the Surface

The world of exchange-traded funds may look like a mass of liquidity and fast profits but lurking just beneath the surface is an array of potential risks and financial mayhem.

Exchange-traded funds are baskets of investments such as stocks, bonds, commodities, currencies and options that track market indexes. But in recent years, traditional ETFs have become increasingly complex, delving into esoteric and risky areas that involve swaps, futures contracts and other derivative instruments.

Leveraged and inverse ETFs are two of those esoteric products. Leveraged ETFs are designed to deliver “multiples” of the performance of the index or benchmark they track. Its cousin, the inverse ETF, works in the reverse by trying to deliver returns that are the opposite of the index’s returns.

The problem many investors make with leveraged and inverse ETFs is that they hold these investments for longer than one trading day. Leveraged and inverse ETFs are not designed for long-term returns. Rather, they try to achieve their stated performance objectives on a daily basis. Holding a leveraged or inverse ETF for any longer may not get you the multiple of the index return you were expecting – and instead create a financial nightmare.

As reported Jan. 13 by Businessweek, ETFs surpassed $1 trillion in assets globally in 2009. The growth has not gone unnoticed by regulators, especially as more complex and riskier versions of the ETF emerged in the market.

For example, the Securities and Exchange Commission (SEC) began examining whether ETFs that use derivatives to amplify returns may have contributed to equity-market volatility in May 2010, when the Dow Jones Industrial Average plunged some 1,000 points in one hour. At the time, the SEC stated that any new ETFs that made substantial use of derivatives would not be approved.

Congress also has taken an interest in the more complex and riskier versions of ETFs, holding several hearings in 2011 on synthetic ETFs and their transparency, leverage and use of derivatives.

So in a nutshell: Leveraged and inverse ETFs aren’t for everyone. In fact, they may not be suitable investments for most retail investors. Not only are these synthetic products complex, highly risky and lack transparency, but they require detailed knowledge and constant monitoring. And while there could be instance where certain trading and hedging strategies justify holding a leveraged or inverse ETF for longer than a single trading day, there’s an even higher probability of losing money.

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