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Inverse Exchange Traded Funds, ETFs: Specialized Investments With Special Risks

Inverse exchange traded funds, ETFs, also known as ultra-short funds, are complex investment products, containing extra risks that investors may be unaware of until it's too late.

An inverse ETF is a relatively new breed of exchanged traded fund. Inverse exchange traded funds are designed to perform as the inverse of whichever underlying index or benchmark is being tracked. Unlike conventional ETFs that move with an index, inverse ETFs track the reverse, or opposite, of the market. Investors profit when the market declines.

As with other synthetic ETFs, inverse ETFs achieve their returns by using several investment strategies, including swaps, futures contracts, and other derivative instruments.

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These strategies, however, entail significant risk because leveraged investment techniques derive their value from other instruments. Moreover, inverse ETFs are structured to achieve their stated performance objectives on a daily basis. Some investors, however, may invest in an inverse ETF expecting the product to meet stated daily performance objectives over the long term, as well.

Because an inverse ETF resets each day, its performance can dramatically diverge from the performance of the underlying index or benchmark. In other words, it's more than possible for an investor to experience massive financial losses even if the long-term performance of the index shows a gain.

Last year, the Securities and Exchange Commission (SEC) and the Financial Industry Regulatory Authority (FINRA) became concerned that investors in inverse ETFs and other synthetic funds failed to understand the additional risks that the products pose. Both agencies jointly issued a warning about inverse ETFs, cautioning investors about their potential downside. Some brokerages, including UBS and Edward Jones & Co., have stopped selling leveraged inverse ETFs altogether.

As inverse and other synthetic exchange traded funds continue to raise the ire of regulators, investors need to take heed. A failure to thoroughly understand these complex and exotic products could ultimately lead to financial disaster.