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Category Archives: Leveraged and Inverse ETFs

SEC & FINRA Issue Warning on Leveraged and Inverse ETFs

FINRA and the SEC want to alert individual investors about performance confusion on the objectives of leveraged and inverse ETFs. Investors should be aware that performance of ETFs over a period longer than one day can differ significantly from their stated daily performance objectives.

The best form of investor protection is to clearly understand these types of investments before dishing out your hard earned money. Start by reading the prospectus, which will provide detailed information on the ETFs’ investment objectives, principal investment strategies, risks, and costs. The SEC’s EDGAR system, as well as search engines, can help you locate a specific ETF prospectus. You can also find the prospectuses on the websites of the financial firms that issue a given ETF, as well as through your broker.

Consider pursuing the advice of an investment professional. Work with someone who understands your investment goals and tolerance for risk. Your investment professional should recognize these complex products, be able to explain if or how they fit your personal goals, and be willing to monitor your investment.

As with all investments, it pays to do your own homework. Only invest if you are confident the product can help you meet your investment objectives and you are knowledgeable and comfortable with the risks associated with these specialized ETFs.

Take a look at the alert issued by the SEC for more information and for real-life examples that illustrate how returns on a leveraged or inverse ETFs over longer periods can differ significantly.

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.

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.

Leveraged, Inverse ETFs Focus of Massachusetts Lawsuit

Massachusetts Secretary of State William Galvin is suing RBC Capital over sales of leveraged and inverse exchange-traded funds (ETFs), accusing the firm of selling the products to clients who didn’t understand what they were buying.

As reported July 20 by Bloomberg, Galvin contends that RBC Capital and Michael D. Zukowski, a former RBC agent, used “dishonest practices” in selling the investments. The lawsuit seeks restitution to Massachusetts investors, a cease and desist order, and an administrative fine.

“The point of the complaint is not that the investors lost money,” Galvin said in a statement. “The dishonesty here is that the investors, and indeed the agent soliciting their investment, did not understand the workings of these funds.”

Galvin’s probe into leveraged and inverse ETFs began in July 2009, shortly after the Financial Industry Regulatory Authority (FINRA) issued a warning about the products and their suitability for long-term investors. Leveraged ETFs use swaps or derivatives to amplify daily index returns; inverse funds are the reverse – they move in the opposite direction of their benchmark.

Galvin alleges that RBC’s Zukowski sold clients “non-traditional” ETFs without proper training or supervision and that RBC failed to have practices in place to prevent unsuitable sales until Dec. 22, 2009, six months after FINRA’s warning.

2010: A Year in Review

Medical Capital Holdings. Securities America. Behringer Harvard REIT I. Main Street Natural Gas Bonds. Tim Durham. Fannie Mae, Freddie Mac Preferred Shares. Goldman Sachs CDO Fraud. Lehman Structured Notes. These names were among the hot topics that dominated the investment headlines in 2010.

In January, Securities America was accused by Massachusetts Secretary of State William Galvin of misleading investors and intentionally making material misrepresentations and omissions in order to get them to purchase private placements in Medical Capital Holdings. Medical Capital was sued by the Securities and Exchange Commission (SEC) in July 2009 and placed into receivership. Its collapse ultimately created about $1 billion in losses for investors throughout the country.

According to the Massachusetts complaint, as well as other state complaints that would follow, many investors were unaware of the risks involved in their Medical Capital private placements. They also didn’t know about the crumbling financial health of the company. Securities America, on the other hand, was fully aware of both, regulators allege.

In February, non-traded real estate investment trusts like the Behringer Harvard REIT I became front-page news, as investors filed complaints over what their brokers did and did not disclose about the investments. In the case of Behringer and other non-traded REITs, including Cornerstone, Inland Western and Inland American, investors found themselves blindsided after discovering their investments were high-risk, illiquid and contained highly specific and lengthy exit clauses.

In March, rogue brokers Bambi Holzer faced charges in connection to sales of private placements in Provident Royalties. Like Medical Capital Holdings, the SEC charged Provident with securities fraud, citing $485 million in private securities sales. In March 2010, the Financial Industry Regulatory Authority (FINRA) formally expelled Provident Asset Management LLC, the broker-dealer arm of Provident.

Ponzi schemes were big news, as well, in March. Heading the list of offenders was Rhonda Breard, a former broker for ING Financial Partners. State regulators contend Breard scammed nearly $8 million from investors in a Ponzi scheme that allegedly had been going on since at least 2007.

In April, Goldman Sachs and its role in the financial crisis faced new scrutiny by Congress. Internal emails became the driving force behind the interest. Eventually, charges were filed by the SEC over a synthetic collateralized loan obligation – Abacus 2007-ACI – that produced about $1 billion in investor losses. Goldman later reached a settlement with the SEC, paying a $550 million fine. The fine remains the biggest fine ever levied by the SEC on a U.S. financial institution. Goldman also acknowledged that its marketing materials for Abacus contained incomplete information.

In May, FINRA stepped up its own scrutiny of non-traded REITs. On its watch list: Behringer Harvard REIT I, Inland America Real Estate Trust, Inland Western Retail Real Estate Trust, Wells Real Estate Investment Trust II and Piedmont Office Realty Trust. In particular, FINRA began to probe the ways in which broker/dealers marketed and sold non-traded REITs to investors.

In June, 49 broker/dealers found themselves named in a lawsuit involving sales of Provident Royalties private placements. The lawsuit, filed June 21 by the trustee overseeing Provident – Milo H. Segner Jr. – charged the broker/dealers of failing to uphold their fiduciary obligations when selling a series of Provident Royalties LLC private placements. Among the leading sellers of private placements in Provident Royalties were Capital Financial Services, with $33.7 million in sales; Next Financial Group, with $33.5 million; and QA3 Financial Corp., with $32.6 million.

In July, Fannie Mae and Freddie Mac were back in the news, as a rash of investors began filing lawsuits and arbitration claims over preferred shares purchased in the companies. In 2007 and 2008, investment firms like UBS, Morgan Stanley, Citigroup, Merrill Lynch and others sold billions of dollars in various series of preferred stock issued by the two mortgage giants. According to investors, however, the brokerages never revealed key information about the preferred shares, including the rapidly deteriorating financial health of Freddie Mac and Fannie Mae and the fact that both companies had a growing appetite for risky lending, excessive leverage and investments in toxic derivatives.

In August, new issues regarding retained asset accounts (RAAs) came to light. Specifically, RAAs allow insurers to earn high returns – 4.8% – on the proceeds of a life insurance policy. Meanwhile, beneficiaries often receive peanuts via interest rates as low as 0.5%. Adding to the issues of RAAs is the fact that the products are not insured by the Federal Deposit Insurance Corp. (FDIC).

In September, new concerns about the suitability of leveraged, inverse exchange-traded funds (ETFs) for individual investors began to crop up. Among other things, regulators cautioned investors about the products and stated that they may be inappropriate for long-term investors because returns can potentially deviate from underlying indexes when held for longer than single trading day.

In October, the ugliness associated with some non-traded REITs gained new momentum. A number of non-traded REIT programs eliminated or severely limited their share repurchase programs. At the same time, some non-traded REITs continued to offer their shares to the public. As of the first quarter of 2010, this group included Behringer Harvard Multi-family REIT I, Grubb & Ellis Apartment REIT, Wells REIT II, and Wells Timberland REIT.

In November, sales of structured notes hit record highs of more than a $42 billion. Leading the pack in sales of structured notes was Morgan Stanley at $10.1 billion, followed by Bank of America Corp., which issued $7.9 billion.

Because of their complexity, structured products are not for those who don’t fully understand them. Moreover, once an investor puts money into a structured product, he or she is essentially locked in for the duration of the contract. And, contrary to promises of principal by some brokers, investors can still lose money – and a lot of it – in structured notes.

Case in point: Lehman Brothers Holdings. Investors who invested in principal-protected notes issued by Lehman Brothers lost almost all of their investment when Lehman filed for bankruptcy in September 2008.

Also big news in November 2010: Tim Durham and Fair Finance. The offices of Fair Finance were raided by federal agents of Nov. 24. On that same day, the U.S. Attorney’s Office in Indianapolis filed court papers alleging that Fair Finance operated as a Ponzi scheme, using money from new investors to pay off prior purchasers of the investment certificates. According to reports, investors were defrauded out of more than $200 million.

The effects of Lehman Brothers’ bankruptcy continued to unfold in December 2010 for many investors who had investments in Main Street Natural Gas Bonds. Main Street Natural Gas Bonds were marketed and sold by a number of Wall Street brokerages as safe, conservative municipal bonds. Instead, the bonds were complex derivative securities backed by Lehman Brothers. When Lehman filed for bankruptcy protection in September 2008, the trading values of the Main Street Bonds plummeted.

Many investors who purchased Main Street Natural Gas Bonds did so because they were looking for a safe, tax-free income-producing investment backed by a municipality. What they got, however, was a far different reality.

Leveraged And Inverse ETFs Not For The Uninformed

Leveraged and inverse ETFs have found themselves under the regulatory microscope recently, which makes it all the more interesting that ProShares has decided to launch eight new exchange-traded funds that aim to magnify their benchmark exposures by 300%. The story was first reported Feb. 12 by Investment News

Leveraged and inverse ETFs try to achieve a return that is a “multiple” of the inverse performance of the underlying index. For Proshares’ new series of ETFs, that means the funds seek a +300% or -300% return of their indices for a single day before fees and expenses. 

In the summer of 2009, several investors initiated lawsuits and arbitration claims involving the Ultra ProShares Funds and UltraShort ProShares Funds. Specifically, investors accuse ProShares of issuing “false and misleading registration statements, prospectuses and additional information” in connection to the funds. As a result of the alleged false promotion of the products, many investors suffered enormous losses. 

In June, the Financial Industry Regulatory Authority (FINRA) issued a statement on leveraged and inverse ETFs, reminding broker/dealers that the products “typically were unsuitable for retail investors” who hold them longer than a single day. FINRA later restated its position, saying that member firms could recommend leveraged and inverse ETFs to retail investors provided that the broker/dealer conducted a suitability assessment of the investor and the ETF itself. 

Massachusetts Secretary of State William Galvin also has taken up the issue of leveraged and inverse ETFs. In July 2009, Galvin began an investigation of the sales materials of companies that sold the funds. The state later sent letter to three ETF leaders – ProShares, Direxion Funds and Rydex Investments. 

The bottom line: Leveraged and inverse ETFs are not for everyone. These types of ETFs provide leverage on a daily basis. Above all, leveraged and inverse ETFs are not a save-and-hold investment – a fact that many retail investors were woefully unaware of. 

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