In the face of regulatory inquiries and pronouncements by the Financial Industry Regulatory Authority (FINRA) on the inherent risks they pose to retail investors, more brokerages are curtailing their activity in leveraged and inverse exchange traded funds (ETFs).
FINRA initially raised questions about inverse and leveraged ETFs when it issued a notice to brokers/dealers on June 11, cautioning them that the instruments may not be suitable investments for retail investors who plan to hold onto the instruments for more than one trading session.
Shortly after FINRA’s edict, Saint-Louis based Edward D. Jones announced its intent to halt sales of leveraged ETFs. UBS and Ameriprise soon followed. Other brokerages, including Charles Schwab, Raymond James Financial and LPL Financial are reviewing their policies concerning ETFs, with some firms posting information on their respective Web sites that inverse and leveraged ETFs “are not right for everyone.”
Leveraged ETFs allow investors to amplify bets on a wide range of markets, while inverse ETFs make profits when prices fall.
Many investors, however, are unaware about the complexities and underlying risks of inverse and leveraged ETFs. Leveraged ETFs, for example, are designed to deliver their stated leverage on a daily basis. If an investor holds the ETF longer than one trading session, it potentially could lead to financial disaster. Leveraged ETFs also employ, as their name implies, leverage. This, in turn, increases the level of financial risk for investors.
On August 5, a lawsuit involving ETFs was filed in New York, accusing ProShare Advisors LLC and others of violating a securities act by failing to disclose the risks of its ProShares UltraShort Real Estate fund (SRS). Among the risks that the complaint contends the inverse leveraged exchange traded fund failed to cite: “Spectacular tracking error.”
Specifically, the lawsuit alleges that the fund’s index fell 39.2% from January 2008 to December 2008, but the fund fell 48.2%, which was not in accordance with ProShares’ stated objective that UltraShort ETFs go up when markets go down.
The complaint is seeking class-action status, according to an Aug. 6 article in the Wall Street Journal.
The dramatic losses of the SRS fund reiterate the inherent risks posed by inverse and leveraged ETFs, especially in times of a volatile market. In the 12 months through July 23, the Dow Jones U.S. Real Estate Index shed 38%, but the ProShares UltraShort Real Estate fund lost 82%, according to the Wall Street Journal article. This year through July 23, the index is down 3.5%, but the fund has slipped 67%.