Exchange-Traded Funds: Risks of the Popular Investment Vehicle

Exchange-traded funds, or ETFs, are investment that can play a role in certain sophisticated trading strategies. Since the first ETF was listed in 1993, these specialized funds have become increasingly popular with investors. Today, there are more than 1,000 ETFs in the United States, allowing investors to allocate their resources in very specific ways. While ETFs first were sold to institutional investors, they increasingly have been sold to individual investors. Today, individual investors own approximately $800 billion in ETFs. But massive ETF investment losses have caused many investors to question the brokers who recommended the investments.

Unfortunately for many individual investors, many brokers do not understand the products, causing some brokers and brokerage firms to misrepresent the investments to investors and sell EFTs to investors for whom ETFs are inappropriate.

ETF Overview

An ETF is an investment vehicle that allows an investor to buy and sell shares in a single security that represents a fractional ownership of a portfolio of securities. The portfolio of securities typically tracks an underlying benchmark or index, such as the S&P 500 Index.

"Non-traditional" ETFs are a growing subset that has been causing confusion and problems for ETF investors. The two primary types of non-traditional ETFs are leveraged and inverse ETFs. Leveraged ETFs or "ultra" ETFs are designed to produce a return that is a multiple of the return of the benchmarked index (200 percent, 300 percent, etc.). Inverse ETFs, also known as "short" funds, attempt to deliver the opposite performance of the tracked index - thus allowing investors to profit on a declining market. Leveraged and inverse ETFs may be combined to create so-called "ultra short" funds (e.g., seeking a return of 2x or 3x the opposite of the benchmark).

A major stumbling block many investors face with non-traditional ETFs is understanding that these funds typically are designed to achieve their stated performance on a daily basis. In other words, non-traditional ETFs generally are not designed to track the return of their underlying benchmark or index for a long holding period. Yet, many brokers do not understand this fact and mistakenly sell them as long-term, buy-and-hold investments, much like a mutual fund.

But the compounded return of ultra and ultra-short ETFs over a year, a week, or even a few days can differ substantially from the actual returns of the index to which the ETF is tied. As a result, investors in these ETFs often are shocked when the performance of their ETFs is substantially worse than the performance of the index that they thought was being tracked. This surprise generally stems from the broker's failure to properly understand and explain the ETFs. As a result, many brokerage firms not have restricted or prohibited the sale of leveraged ETFs to many individual investors.

It is crucial that brokers and investors monitor their leveraged ETFs on a daily basis. The failure to do so can lead to devastating investment losses. Treating these ETFs as long-term, buy-and-hold investments can be a recipe for financial disaster. Leveraged ETFs may not belong in the portfolios of individual investors at all, as their complexity makes them more suited to professional traders.


A Better Understanding of Your Rights

Most investors rely on a brokerage firm to help guide investment strategies. But, even professionals can get swept up in the popularity of a relatively new investment vehicle and give bad advice. Many brokers fail to take the time to understand the complex products that they sell and brokerage firms often do a poor job educating their brokers about those products. When stockbroker misconduct impacts your financial situation, you may have legal recourse.

The Financial Industry Regulatory Authority ("FINRA") has a series of rules that brokers and brokerage firms must follow. Among other things, before recommending a security (including an ETF), a firm must understand the product and have a reasonable basis to believe that the product is suitable as an investment tool and suitable for the specific customer. Failing to understand a product and making false, exaggerated, or misleading statements are prohibited. If you believe you have suffered investment losses due to a brokerage firm's or a broker's misconduct, contact a stockbroker fraud attorney today to explore your legal options.


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