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Exchange Traded Funds (ETFs)

Exchange Traded Funds (ETFs)

img_20Exchange traded funds, ETFs, have grown increasingly popular in recent years – but 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. Investors use these to try to profit when the stock market goes down (“SDS”) or when it is volatile, up one day and down the next (VIX). Even though leveraged and inverse ETFs contain some characteristics common to traditional ETFs, they’re also very different.

These ETFs have unique risks. Specifically, leveraged (2X or 3X) 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 because options expire every day, creating a “gap” between the closing price and the next day’s opening price.

  • Leveraged Exchange Traded Funds – such as DIG, SPXL, MIDU, TNA, ERX, and Direxion ETFs
  • Inverse Exchange Traded Funds – such as DUG, SDS, SPXS, and DRV
  • Synthetic Exchange Traded Funds – such as VIX and HEGE

Leveraged ETFs work by trying to double or triple the return of a particular index daily by using margin. An inverse ETF moves in the opposite direction of the index being tracked. If the index drops 5%, the inverse ETF should rise 5%. The 2X ETF should rise 10% and the 3X should rise 15%. But, if the market goes up, the ETF goes down by the same percentages. This can create whopping losses quickly. 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 than other mutual funds and ETFs.

The Financial Industry Regulatory Authority (FINRA) 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: If your broker has recommended leveraged or inverse ETFs to you and you have lost money, please contact Diane Nygaard at (913) 485-5014 for a free consultation.

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