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Regulators Warn Investors About Leveraged and Inverse ETFs

The SEC and FINRA issued a joint release warning individual investors of the dangers of leveraged and inverse exchange traded funds (ETFs). According to the alert, these specialized and complex products, designed to achieve their stated performance on a daily basis, pose extra risk for individual investors, who tend to buy-and-hold. The thrust of the alert is that "investors should be aware that performance of these ETFs over a period longer than one day can differ significantly from their stated daily performance objectives."

The release describes leveraged ETFs as:

Leveraged ETFs seek to deliver multiples of the performance of the index or benchmark they track. Inverse ETFs (also called “short” funds) seek to deliver the opposite of the performance of the index or benchmark they track. Like traditional ETFs, some leveraged and inverse ETFs track broad indices, some are sector-specific, and others are linked to commodities, currencies, or some other benchmark. Inverse ETFs often are marketed as a way for investors to profit from, or at least hedge their exposure to, downward moving markets.

Leveraged inverse ETFs are described as:

Leveraged inverse ETFs (also known as “ultra short” funds) seek to achieve a return that is a multiple of the inverse performance of the underlying index. An inverse ETF that tracks a particular index, for example, seeks to deliver the inverse of the performance of that index, while a 2x (two times) leveraged inverse ETF seeks to deliver double the opposite of that index’s performance. To accomplish their objectives, leveraged and inverse ETFs pursue a range of investment strategies through the use of swaps, futures contracts, and other derivative instruments.

The primary risk the alert warns of is that leveraged and inverse ETFs "are designed to achieve their stated objectives on a daily basis. Their performance over longer periods of time -- over weeks or months or years -- can differ significantly from the performance (or inverse of the performance) of their underlying index or benchmark during the same period of time. This effect can be magnified in volatile markets." The release also includes some "real-life" examples of the magnified negative effects these kinds of ETFs can have for investors who make the mistake of holding them for longer periods.

As with all investments, the alert warns that the best way for investors to protect themselves is to understand thoroughly the instruments or vehicles before investing. This includes reading the prospectus, seeking the advice of a qualified investment professional who understands these products, and also understands the investor's individual risk tolerance and investment goals. With respect to leveraged or inverse ETFs, the release advises investors to ask:

  • How does the ETF achieve its stated objectives? And what are the risks?
  • What happens if I hold longer than one trading day?
  • Is there a risk that an ETF will not meet its stated daily objective?
  • What are the costs?
  • What are the tax consequences?

The full text of the SEC and FINRA investor alert is available at: http://www.sec.gov/investor/pubs/leveragedetfs-alert.htm