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Category Archives: Exchange Traded Funds (ETFs)

Regulators & Investors Anxiety towards ETF’s Grows

Recently, Exchange-Traded Funds are being perceived as scary to many in the investment world. Some financial advisers say they are now guarded about recommending the products to clients. Lots of questions arose about the products’ trading and marketing in the days following the Aug. 24 “flash crash,” when prices of several ETFs appeared to come unbalanced from their primary value.

According to the Wall Street Journal, for those looking to practice “safe ETF,” here are five questions to consider:

  1. Do ETF investors have enough safeguards?

There are plenty of consumer-protection regulations surrounding ETFs, but that doesn’t mean the rules are airtight.

Initially created to track indexes, ETFs are similar to mutual funds in that they mostly consist of baskets of stocks and bonds, but they are different in that they trade on exchanges all day like stocks.

Because of ETFs’ hybrid nature—and because there is no separate “ETF law”—they are governed partly by the Investment Company Act of 1940, which sets rules for mutual funds, and partly by the Securities Exchange Act of 1934, which sets rules for brokers and exchange oversight.

The problem is, neither law was designed to account for a product that relies on second-by-second pricing of both itself and a collection of other securities. As Aug. 24 showed, ETFs in rough markets can fall harder than the prices of their underlying assets. In normal markets, ETF traders who profit from zooming in and out of the ETFs and their underlying holdings keep the values in line, but investors have been startled to see that balance can be disrupted at times.

ETFs are a “digital-age technology” governed by “Depression-era legislation,” analysts at fund-tracker Morningstar have said.

Exchanges, as well as some fund providers, are examining how to prevent these rare trading anomalies. Meanwhile, the risk that ETFs may not always trade or price as expected is one that investors need to consider.

  1. Everyone is doing it. Do I need to be invested in ETFs?

You don’t need ETFs any more than you need to buy the latest iPhone. One reason investors have poured money into ETFs is their tax efficiency and typically low fees (which is possible because 93% of the products track indexes with low turnover, according to researcher XTF Inc., which is what keeps down transaction costs and realized capital gains).

However, ETFs aren’t the only game in town when it comes to low-cost investing. In certain asset classes, index-tracking mutual funds can be just as cheap as comparable ETFs. What’s more, while ETFs are known for their tax efficiency, that may not be of great importance to everyone, especially those who don’t plan to hold the funds in taxable accounts.

What matters most—and what investors should focus on—is whether a fund’s underlying portfolio fits with their goals, says Rick Ferri, the founder of Portfolio Solutions and long a proponent of index investing. “Look under the hood,” he advises, because many funds that seem similar really aren’t and will produce very different results. From there, investors can assess the product’s structure and whether the costs involved in holding or trading it are a good fit for them.

For some people, ETFs’ intraday tradability is a strong selling point. Unlike mutual funds, which can be bought or sold only at each day’s closing net asset value (NAV), ETFs can be traded all day on exchanges, which usually makes it easier for investors to get into or out of positions at a market price quickly (except, of course, on days like Aug. 24). “How important is that to you?” Mr. Ferri asks.

Others like ETFs because they offer a way to get low-cost exposure to corners of the market that used to be inaccessible to most individual investors.

“ETFs have democratized access to a broad array of asset classes,” says Onur Erzan, director of McKinsey & Co.’s North American asset-management practice. “This has improved the ability of investors and advisers to construct more granular and efficient portfolios,” he says. These include specific segments of the government and corporate debt markets, including high-yield securities (junk bonds) and bank loans, as well as hard-to-reach economies such as China, India and other developing markets, domestic and international sectors and industries, and socially responsible themes. On top of these, some asset managers offer currency hedging within the ETF and leveraged or short daily exposure geared more toward professional traders.

  1. What happened in August and could it happen again?

Critics say stock-market swings on Aug. 24 exposed the flaws in ETFs they have been warning about for years. Proponents say ETFs mostly were caught in the crossfire of marketwide trading issues that had little to do with them. One thing is for sure: It wasn’t the first time ETFs have surprised investors.

ETFs were in focus during the flash crash of 2010, in which bids on dozens of ETFs (and other stocks) fell as low as a penny a share, and again in 2013, when municipal-bond ETFs traded at a discount to their net asset values during the “taper tantrum,” when bond yields jumped.

And then came Aug. 24. The debacle was a test for the labyrinth of new regulations put in place after the 2010 flash crash, and it wasn’t pretty. As the Dow Jones Industrial Average plunged 1,000 points, triggers went off for mandated halts in many stocks held by ETFs, as well as the ETFs themselves. Then, a number of ETFs stunned investors by trading at prices far below their NAV, highlighting concerns that ETFs might not be as easy to move in and out of at “fair” prices when markets are in disarray.

In response to the Aug. 24 debacle, the three U.S. listing exchanges—the New York Stock Exchange, ICE -0.85 % Nasdaq Stock Market NDAQ -0.58 % and BATS Global Markets Inc.—indicated they will no longer accept stop-loss orders on any traded securities. Such orders seem to protect investors by triggering a sale when a target price is met, but at a certain point in a falling market they become “market orders” that are completed at any price. The NYSE is considering a way to flag “aberrant” ETF trades.

Meanwhile, it may be more advisable than ever for investors to use limit orders—orders to buy or sell a security at a specific price or better, literally putting a limit on how low the price can go.

“Have good trading hygiene,” says Dave Nadig, director of ETFs for FactSet. “The vast majority of ETFs deliver on their core promise to investors. But if you trade them poorly, that’s probably on you.”

  1. What parts of the ETF market should I be most wary of?

Investors should be wary of “any area where there’s a lot of product development,” Mr. Nadig says.

Regulatory issues aside, the “safety” of any financial product largely depends on how well an investor understands it, and in this regard, the ETF ecosystem has grown more complicated in recent years.

The idea behind the earliest index-tracking ETFs was pretty simple: provide investors with market-cap-weighted exposure to entire markets or giant chunks of markets at the lowest possible cost.

Since then, ETF offerings have proliferated. Anyone with a brokerage account can now choose from among more than 1,800 different exchange-traded products, covering almost every conceivable market sector, niche and trading strategy. While some advisers love that—it gives them an easy, low-cost way to provide clients with exposure to certain market segments—the concern is that some less-sophisticated investors may be buying complex, heavily marketed funds without fully understanding what they are getting.

“ ‘Smart beta,’ in particular, creates real due-diligence problems,” Mr. Nadig says, referring to the growth in index products that shun traditional market-cap weightings and instead weight holdings according to an investment factor such as volatility, value, quality or momentum.

“With some new factor-based ETFs, it can be very hard to really understand what you are getting and why,” says Mr. Nadig. It requires understanding how the fund is segmenting securities based on a factor such as value, how it is weighting stocks in the portfolio, how often its index is rebalanced, and whether there are stock or sector limitations or weights.

If you don’t have the knowledge or time to build and manage a complex portfolio, it may be best to stick with broad-based index ETFs with significant assets and trading volume, experts say, and leave the niches to the pros.

  1. Where do ETFs go from here?

Even as ETFs continue to surge in popularity, gobbling up $200 billion in investors’ dollars so far this year, their emerging dominance in the passive-investing world is already being challenged.

Online broker Motif Investing, for example, offers low-cost direct investing in baskets of up to 30 stocks tied to investment themes, industries and sectors. It charges only $9.95 per “motif” trade or rebalance order.

Among “robo advisers,” which are automated investing services, Wealthfront now offers direct indexing for clients with more than $100,000. Instead of using an ETF, Wealthfront will buy anywhere from 100 to 1,000 individual stocks, proportional to their share in Standard & Poor’s market-cap-weighted U.S. indexes, and harvest tax losses at the individual security level. The company charges 0.25% of assets annually manages the first $10,000 free.

Traditional mutual-fund managers, meanwhile, are looking to ride a new investment vehicle developed by a unit of Eaton Vance EV -2.88 % —an exchange-traded managed fund that will trade all day like a stock but won’t have to fully disclose its portfolio like other actively managed ETFs—to sustain interest in their investment strategies. Similarly, other issuers of index ETFs, including BlackRock, State Street Corp. STT -2.08 % ’s State Street Global Advisors and Vanguard Group, are looking at ways to reintroduce ETF-inclined investors to active strategies.

“Investors will ultimately embrace them only if they are convinced of the incremental value versus some of the technicalities,” says McKinsey’s Mr. Erzan.

So far, it has all been a tough sell.

Spruce Alpha Fund Decimates its Investors

As reported by the New York Times on September 30, 2015 (“Risky Strategy Sinks Small Hedge Fund”), the Spruce Alpha LP Fund, a Stamford, Connecticut based hedge fund which had been pitched to investors as offering large returns in periods of market turbulence, lost 48% of its value during the month of August 2015.

Spruce Alpha, managed by Spruce Investment Advisors, was launched about a year ago and reportedly used a complex and controversial trading strategy that involved derivatives to amplify returns from trading in exchange-traded funds, or E.T.F.s, of various strategies.

“To sell the fledgling fund to investors, Spruce emphasized not only an outsize hypothetical performance going back as far as 2006,” but according to documents reviewed by the New York Times, the fund’s back-testing projections in documents provided to potential investors indicated that “at the height of the 2008 financial crisis, investors would have had a gain of more than 600 percent.”

As noted by the New York Times, “for the investors who have lost nearly half of their investment, however, it is a cautionary tale of relying on glowing, but backdated, performance data. Back-tested results in hedge fund marketing materials have long drawn scorn from some in the hedge fund world. The results are typically recreated with the benefit of hindsight, making it easier for a fund to post hypothetical good results.”

If you are an individual or institutional investor who has any concerns about your investment in the Spruce Alpha LP Fund, please contact us for a no-cost and no-obligation evaluation of your specific facts and circumstances. You may have a viable claim for recovery of your investment losses by filing an individual securities arbitration claim with the Financial Industry Regulatory Authority (FINRA).

Risks Associated with ETFs are Exposed by Volatility in the Markets

As reported by The Wall Street Journal on September 14, 2015, (“The Problem With ETFs”), one of Wall Street’s most popular products –Exchange Traded Funds – faces renewed questions after the wild stock-market gyrations in August exposed cracks that many critics had warned about for months.

Investors have poured hundreds of billions of dollars into ETFs over the past decade, drawn by low fees and the prospect of being able to buy or sell a mutual-fund-like product whenever they want like a stock.

But, according to the article, trading records and conversations with investors show that ETFs couldn’t keep that promise when the Dow Jones Industrial Average dropped more than 1,000 points, in the first minutes of trading on Aug. 24, as “steep share-price declines triggered a slew of trading halts that started in individual stocks and cascaded into ETFs. Dozens of ETFs traded at sharp discounts to the sum of their holdings, worsening losses for many fund holders who sold during the panic. The strange moves highlighted concerns raised by academics and others over the years that ETFs might not be as easy to move in and out of as advertised in times of stress. For investors of all sizes, the problems set off alarms that a core component of their portfolios might not always function as expected.”

This recent market volatility has once again placed a spotlight on the “growing concern about how bond ETFs, a popular niche, will perform if investors rush to the exits, as some predict might happen when U.S. interest rates rise” – what some observers refer to as “a recipe for a breakdown” that could be significant and prolonged.

If you are an individual or institutional investor who has any concerns about ETF investments having been recommended for purchase in either your retirement or non-retirement accounts, please contact us for a no-cost and no-obligation evaluation of your specific facts and circumstances. You may have a viable claim for recovery of your investment losses by filing an individual securities arbitration claim with the Financial Industry Regulatory Authority (FINRA).

FINRA: A Year in Review, Part 1

The Financial Industry Regulatory Authority (FINRA) has released its end-of-the-year report card on various regulatory achievements it made in 2012, along with progress highlights in detecting fraudulent activity, increasing transparency of securities markets and protecting investors.

Among FINRA’s key accomplishments in 2012:

  • Fines totaling $68 million were assessed.
  • A record $34 million in restitution to harmed customers was ordered.
  • 1,541 disciplinary actions (an increase of 53 from 2011) were brought against FINRA-registered individuals and firms.
  • 30 firms were expelled from the securities industry; 294 individuals were barred; and 549 brokers were suspended from association with FINRA-regulated firms.
  • 692 matters involving potential fraudulent conduct were referred by FINRA’s Office of Fraud Detection and Market Intelligence (OFDMI) to the Securities and Exchange Commission (SEC) and other federal or state law enforcement agencies, including 347      insider trading referrals and 260 fraud referrals.

Disciplinary actions levied by FINRA in 2012 entailed several high-profile cases involving complex financial products, including exchange-traded funds (ETFs), structured products and non-traded REITs, as well as research analyst conflicts, inadequate disclosure and mispricing.

Among the 2012 cases: David Lerner Associates. FINRA sanctioned David Lerner Associates, the firm’s founder, President and CEO, and the firm’s head trader in an action related to the non-traded Apple REITs involving suitability and supervision violations. The settlement also consolidated numerous matters, including a municipal and CMO markup case, a pending enforcement investigation of more recent municipal and CMO markups, and 10 pending market regulation matters involving municipal markups identified through surveillance reviews.

FINRA also sanctioned Citigroup Global Markets, Inc; Morgan Stanley & Co., LLC; UBS Financial Services; and Wells Fargo Advisors, LLC a total of more than $9.1 million for selling leveraged and inverse ETFs without reasonable supervision and for not having a reasonable basis for recommending the securities. Fines totaling more than $7.3 million were levied against the firms, which were required to pay a total of $1.8 million in restitution to certain customers who made unsuitable leveraged and inverse ETF purchases. Similar cases were brought by FINRA against Merrill Lynch and Scott & Stringfellow.

Finally, Merrill Lynch was fined $450,000 for supervisory failures relating to sales of structured products to retail clients. The firm relied upon automated exception-based reporting systems to flag transactions and/or accounts that met certain pre-defined criteria, but did not specifically monitor for potentially unsuitable concentration levels.

Check back for Part 2 of FINRA’s 2012 Year in Review and the various investor protection and transparency initiatives launched in 2012.

Complex Investment Products in Hot Water With FINRA

Brokerage firms and registered reps selling private placements, inverse and leveraged exchange traded funds (ETFs), structured notes and other complex investment products have been put on notice by the Financial Industry Regulatory Authority (FINRA). In a newly issued regulatory notice, FINRA outlined certain due-diligence and supervisory policies and procedures that firms must have in place when selling such products and that the investments themselves can be expected to face greater regulatory scrutiny in the future.

“Registered representatives should compare a structured product with embedded options to the same strategy through multiple financial instruments on the open market, even with any possible advantages of purchasing a single product,” Regulatory Notice 12-03 said in part.

As in previous notices issued by FINRA, Notice 12-03 reiterated the fact that firms should consider whether less complex products can achieve the same objectives for investors. The notice further stated that post-approval follow-up and review are particularly important for any complex investment product.

In recent years, regulators have issued a number of enforcement and disciplinary actions in cases involving complex investments. Two high-profile cases occurred in 2009, when the Securities and Exchange Commission (SEC) filed fraud charges against Medical Capital Holdings and Provident Royalties LLC over the private placements issued by both entities.

Several state regulators, including Massachusetts, also have filed regulatory actions against various broker/dealers that sold Medical Capital and Provident private placements to investors.

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.

Leveraged, Inverse ETFs: A Jekyll & Hyde Investment?

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.


The Ongoing Dangers of Synthetic ETFs

Synthetic exchange-traded funds (ETFs) have gotten a bad rap lately – and with good reason. Regulators and many financial experts believe that synthetic ETFs are too complex for retail investors and that they may not fully understand the counterparty and derivatives risks they are actually taking on.

Many synthetic exchange-traded funds rely on derivatives to generate returns instead of holding or owning the underlying securities as traditional ETFs do. Synthetic ETFs include inverse and leveraged funds. A leveraged ETF is designed to accelerate returns based on the rate of growth of the index being tracked. For example, if the underlying index moves up 3%, a 2x leveraged ETF would move up by 6%.

An inverse ETF does the opposite. It is designed to perform as the inverse of whatever index or benchmark is being tracked. Inverse ETFs funds work by using short selling, derivatives and other techniques involving leverage.

And with leverage, there always comes risk. As reported Nov. 17 by Investment News, Laurence D. Fink, chief executive officer of BlackRock, Inc., is a staunch critic of some exchange-traded funds. In particular, Fink takes issue with ETFs provided by Societe Generale SA.

“If you buy a Lyxor product, you’re an unsecured creditor of SocGen,” said Fink in the Investment News story. Providers of synthetic ETFs should “tell the investor what they actually are. You’re getting a swap. You’re counterparty to the issuer.”

And therein is the problem.

Counterparty risk means there is a chance that the swap provider could go belly up, leaving investors out in the cold. Remember Lehman Brothers? Following Lehman’s collapse in 2008, many investors quickly discovered that their investments were essentially worthless.

Inverse/Leveraged ETFs a Concern For Investors

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.

Exchange-Traded Funds Face SEC Scrutiny

Exchange-traded funds (ETFs) are the latest investment product to find themselves in the hot seat with the Securities and Exchange Commission (SEC). At a Senate Banking subcommittee hearing held today, the SEC announced that it was launching a sweeping review of exchange-traded funds.

Among other things, the SEC says it will be looking at investor disclosures, the transparency of the underlying instruments in which ETFs invest, liquidity levels, fair valuations, and the potential impact of ETFs on market volatility.

The SEC’s review also entails “gathering and analyzing detailed information about specific products,” said SEC Investment Management Director Eileen Rominger.

Recent scrutiny of exchange-traded products has been fueled, in part, by the growth of more complex exchange-traded products that many experts contend are far too complex and confusing for the average retail investor. In particular, regulators are concerned about leveraged and inverse ETFs – funds designed to amplify short-term returns by using debt and derivatives.

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