Sunday, August 23, 2009

ETFs are dangerous

Exchange-traded funds (ETFs) that use leverage or perform inversely (opposite) to an index or benchmark they track are growing in number and popularity. The controversy and danger surrounding these products was featured in recent articles in the Wall Street Journal (“FINRA Urges Caution on Leveraged Funds,” by Daisy Maxey), and InvestmentNews (“Leveraged ETFs: Handle with care”), and in Regulatory Notice 09-31 published by the Financial Industry Regulatory Authority (FINRA). FINRA and others are concerned that leveraged and inverse ETFs are being inappropriately marketed and sold to retail investors for whom they are unsuitable without an adequate explanation of the risks.

Leveraged and inverse ETFs are extraordinarily risky and complex securities. Leveraged ETFs are designed to deliver multiple times the return of their benchmark, while inverse ETFs move in the opposite direction from their benchmark. Leveraged inverse ETFs multiply the inverse movement.

Like futures contracts and options, these products are designed to be used as a part of sophisticated trading strategies. Unlike futures contracts and options, they are typically not designed to be held more than one day. As a result of compounding, the price movement of such ETFs can differ markedly from their underlying index or benchmark, FINRA warns. In other words, you could lose a lot even when the underlying benchmark gains. FINRA’s illustrations are sobering:

• The Dow Jones U.S. Oil & Gas Index gained 2 percent, while an ETF seeking to deliver twice the index's daily return fell 6 percent and the related ETF seeking to deliver twice the inverse of the index's daily return fell 26 percent.
• An ETF seeking to deliver three times the daily return of the Russell 1000 Financial Services Index fell 53 percent while the index actually gained around 8 percent. The related ETF seeking to deliver three times the inverse of the index's daily return declined by 90 percent over the same period.

With this in mind, FINRA has warned brokers about their sales practice obligations when selling leveraged and inverse ETFs. Among other things, brokers are required to thoroughly understand they products they sell, make a determination, backed by appropriate information, that the product is suitable for the customer’s investment objectives and risk tolerance. Furthermore, brokers are legally obligated to explain all material facts regarding an investment before the sale.

Given the complexity of these products and the realities of the securities brokerage industry, the chance that any retail broker thoroughly understands them is zero. According to FINRA, in its typically understated fashion, “inverse and leveraged ETFs typically are not suitable for retail investors who plan to hold them for more than one trading session, particularly in volatile markets.” In fact, they are not suitable for most retail investors, period.

If you have suffered losses in leveraged and/or inverse ETFs, you should contact qualified counsel to determine your potential rights and remedies.

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