Danger Permeates Exotic ETFs
Investors have poured $1 trillion into “bewildering array” exchange-traded funds, while they offer some advantages over mutual funds, they also come with risks, according to a recent CNBC/Bankrate.com article titled “Are Exchange-Traded Funds Dangerous?”
The answer is that many ETFs are dangerous. Leveraged and inverse exchange traded funds are especially risky, as are many of the more exotic or narrowly focused ETFs, according to the article. Estimates put the number of exchange traded funds at over 1,000, and more than half of them were launched in the last two or three years.
The least risky are exchange-traded funds that mirror a broadly diversified index such as the Standard & Poor's 500. The benefits of such ETFs are liquidity, transparency, low expenses, diversification and tax efficiency.
But there are other exchange-traded funds that lack some or all of these benefits and come with significant risks: lack of diversification and high volatility among them. An exchange-traded fund that contains every stock in a narrow sector is not diversified, and that lack of diversification means greater volatility.
Twenty-five percent of exchange traded funds fell sixty percent of more in the May 6th flash crash when the Dow fell nearly 1,000 points in 15 minutes before snapping back. Seventy percent of the trades that were canceled involved exchange traded funds.
Exchange traded funds have become a huge part of the market. ETFs currently comprise about forty-five percent of the overall exchange volume, according to the article.
"Sectors are getting thinner and thinner," Tom Lydon, editor of ETF Trends, was quoted as saying, adding: "And some of these are riskier than others." For example, there's now a small cap Brazilian ETF. "There are only a handful of stocks in the index," he says. "What happens if one of those companies has lousy earnings?" A sharp decline in price, according to the article.
"Specializing in a sector can get you killed," Jack Colombo, editor of Closed End Fund & ETF Report, was quoted as saying. "They can be profitable or a disaster."
Hedge fund replicator exchange traded funds, which pack high-octane derivatives under the hood, are being marketed to anyone with $50, which includes many who cannot afford to lose their investment. Regulators are concerned. Hedge funds are generally high-risk, high-reward investment vehicles that are largely unregulated and are unsuitable for most investors.
Other extreme exchange traded funds trade volatile commodities futures. Even more extreme exchange traded funds are leveraged and inverse, whose net asset values move in multiples of a given basket of securities, or in the opposite direction. While these funds are sometimes marketed as hedges or “insurance” against adverse market moves, the danger lies in the way they are really sold and used, and that is to speculate in the hope of above-market returns.
John Bogle, the founder of Vanguard and the creator of the first index mutual fund in 1975, is one of those who believe that extreme exchange traded funds may blow up in investors’ faces. “It’s insanity,” Bogle was quoted as saying. “This is a classic case of Wall Street trying to capitalize on the worst instincts of investors.”
Brokers and firms that sell exchange traded funds have a duty to understand and explain the risks of the investment they are selling, and, at a minimum, must not recommend an investment without a reasonable basis to believe that it is suitable for the investor.
Page Perry, LLC is an Atlanta-based law firm with over 125 years collective experience representing investors in securities-related litigation and arbitration. While past results are not indicative of future success, Page Perry’s attorneys have recovered over $1,000,000 for clients on more than 30 occasions. Page Perry’s attorneys are actively involved in representing institutional and corporate investors that lost money in ETFs. For further information, please contact us.
