Concerns about Leveraged Exchange Traded Funds (ETFs) Increase
The Securities and Exchange Commission (SEC), the North American Securities Administrators Association (NASAA), and the Financial Industry Regulatory Authority (FINRA) have all recently warned that leveraged exchange traded funds (ETFs) are very dangerous investments and not suitable for most retail investors. Moreover, the State of Massachusetts has announced an investigation into the sales practices of brokerage firms selling ETFs.
ETFs are stock or bond funds that are sold on stock exchanges. Typically they are index funds that track a benchmark such as the Dow Jones Industrial Average or the S&P 500, although they can be managed. Leveraged EFTs are a specialized form of ETF that uses leverage, or borrowed money, with the goal of outperforming an index during a trading session or other short-term time frame. For example, a leveraged ETF may attempt to achieve gains that are 2 or 3 times the benchmark index, while an inverse leveraged ETF may attempt to achieve 2 or 3 times the opposite of how the index performs as part of a short selling or hedging strategy. Either way, leveraged ETFs are much more sensitive to market movements than non-leveraged ETFs due to the inherent nature of leverage, which tends to magnify both gains and losses. Because a leveraged ETF can lose many times its value during a single day, only the most sophisticated investors—with the ability to monitor them closely during the market session—should invest in such funds.
The recent regulatory warnings about leveraged ETFs arise from the fact that brokerage firms have been marketing ETFs in a way that appeals to retail investors.
One provider of ETFs has taken out full page ads captioned “ETFs Built to Rise When Treasurys Fall,” which could be construed as a direct pitch to conservative retail investors for whom ETFs would not be a suitable investment. While such ads may contain fine print disclaimers, ETFs are such complex investment instruments that marketing materials about them are capable of being misinterpreted by the average retail investor. The potential for unsophisticated investors to be misled by ETF advertising, as well as by unscrupulous brokers and advisers who may recommend such investments, has prompted the regulatory concerns.
According to the FINRA warning, leveraged ETFs are generally not suitable for retail investors who intend to hold them for more than a day. ETF providers have responded by stating that ETFs can be held for more than a day as long as they are properly monitored, but few retail investors have the capacity to do that—which would not only require an intimate understanding of the complex relationship between the ETF and the benchmark, but the ability to recognize deviations in that relationship and to take corrective action before those deviations widen into exponential losses.
Craig T. Jones, an attorney with the Atlanta law firm of Page Perry LLC, “some investors may have been put into ETFs without knowing what they were. If that has happened and the investor sustained substantial losses, the investor may have a variety of claims against his or her broker.” Jones’ firm represents investors all over the country in arbitrations and lawsuits stemming from ETFs and other broker misconduct.
