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ETFs Go to Capitol Hill

Inverse and leveraged exchange-traded funds (ETFs), which have faced ongoing scrutiny by regulators in recent months, are now garnering the attention of lawmakers on Capitol Hill.

As reported May 3 by Investment News, Sen. Jack Reed, D-R.I., chairman of the Senate Banking Subcommittee on Securities, Insurance and Investment, announced that he is continuing to monitor the complex financial products and plans to follow up on a hearing he held last year with another one in the near future.

Earlier this week, leveraged and inverse ETFs took center stage when the Financial Industry Regulatory Authority (FINRA) levied $9.1 million in penalties on four major banks – Citigroup Global Markets, Morgan Stanley & Co., UBS Financial Services and Wells Fargo Advisors – for their role in selling the risky investments to retail clients who, because of their conservative risk profiles, should never have purchased them.

According to FINRA, the brokerages failed to adequately educate their own representatives about the complexities – and inherent risks – of leveraged and inverse ETFs. The same representatives then marketed and sold the products to investors who were uneducated about the potential dangers that inverse and leveraged ETFs hold.

Exchange-traded funds are essentially baskets of investments – stocks, bonds, commodities, currencies and options – that track market indexes. In recent years, however, traditional ETFs have grown increasingly complex, delving into esoteric and risky areas that involve swaps, futures contracts and other derivative instruments.

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

The problem that many investors make with leveraged and inverse ETFs is that they hold these investments for longer than one single trading day. Leveraged and inverse ETFs are not designed for long-term returns. Rather, their goal is to try and achieve their stated performance objectives on a daily basis. Holding a leveraged or inverse ETF for a longer period of time may result in a financial nightmare.


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