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Exchange Traded Funds (ETFs)

Exchange traded funds, ETFs, have grown increasingly popular in recent years – and they've also become more complex, exotic and risky.

Leveraged and inverse ETFs in particular have become a new source of concern for both regulators and investors. Even though leveraged and inverse ETFs contain some characteristics common to traditional ETFs, they're also very different.

Synthetic ETFs contain unique risks. Specifically, leveraged and inverse ETFs are designed to achieve their stated performance objective on a daily basis. Investors who hold these investments for longer than one trading day could potentially see their entire investment portfolio vanish overnight.

Leveraged ETFs work by trying to double or triple the return of a particular index daily. An inverse ETF moves in the opposite direction of the index being tracked. If the index drops 5%, the inverse ETF should rise 5%. Because of compounding and leverage, leveraged and inverse ETFs are not designed to deliver long-term returns.

In addition to their complex structure, there are other issues of concern regarding synthetic ETFs. One is the derivatives that they invest in, which, in turn, introduces counterparty risk for the investor.

Another difference between traditional ETFs and leveraged and inverse ETFs is cost. Leveraged and inverse ETFs are significantly more expensive in terms of fees and commissions.

In August, both the Financial Industry Regulatory Authority and the Securities and Exchange Commission (SEC) issued a statement on the risks of leveraged and inverse ETFs. In part, the warning read:

"These products are complex and can be confusing. Investors should consider seeking the advice of an investment professional who understands these products, can explain whether or how they'll fit with the individual investor's objective and who is willing to monitor the specialized ETF's performance for his or her customers."

The bottom line: Investors need to know the risks of leveraged and inverse ETFs before they buy.

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