Overview of Inverse and Leveraged Exchange-Traded Funds (ETFs)
Did your broker recommend investing in leveraged or inverse ETFs?
The SEC and the Financial Industry Regulatory Authority (FINRA) recently issued an Investor Alert about non-traditional exchange-traded funds because it believes individual investors may be confused about the performance objectives of leveraged and inverse ETFs. Leveraged and inverse ETFs typically are designed to achieve their stated performance objectives on a daily basis. Some investors might invest in these ETFs with the expectation that the ETFs may meet their stated daily performance objectives over the long term as well. Investors should be aware that the performance of these ETFs over a period longer than one day can differ significantly from their stated daily performance objectives.
What are Exchange-Traded Funds (ETFs)?
Exchange Traded Funds (ETFs) are typically registered investment companies whose shares represent an interest in a portfolio of securities that track an underlying benchmark or index. Some ETFs that invest in commodities, currencies, or commodity- or currency-based instruments are not registered as investment companies.) Unlike traditional mutual funds, shares of ETFs typically trade throughout the day on a securities exchange at prices established by the market.
ETFs have evolved over the years, becoming more complex. Investors considering ETFs should evaluate each investment closely and not assume all ETFs are alike. In the last few years, a number of leveraged and inverse ETFs have been introduced to the market that are very different from the traditional variety of ETFs.
What are Leveraged and Inverse ETFs?
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 (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.
Most leveraged and inverse ETFs “reset” daily, meaning that they are designed to achieve their stated objectives daily. 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. This effect can be magnified in volatile markets. As the examples below demonstrate, an ETF that is set up to deliver twice the performance of a benchmark from the close of trading on Day 1 to the close of trading on Day 2 will not necessarily achieve that goal over weeks, months, or years.
Real-Life Examples Illustrate Returns & Performance due to Time Period
The following two examples illustrate how returns on a leveraged or inverse ETF over longer periods can differ significantly from the performance (or inverse of the performance) of their underlying index or benchmark during the same period.
- Between December 1, 2014, and April 30, 2016, a particular index gained 2 percent. However, a leveraged ETF seeking to deliver twice that index’s daily return fell by 6 percent—and an inverse ETF seeking to deliver twice the inverse of the index’s daily return fell by 26 percent.
- During that same period, an ETF seeking to deliver three times the daily return of a different index fell 53 percent, while the underlying index actually gained around 8 percent. An ETF seeking to deliver three times the inverse of the index’s daily return declined by 90 percent over the same period.
How can this apparent breakdown between longer term index returns and ETF returns happen? Here’s a hypothetical example: let’s say that on Day 1, an index starts with a value of 100 and a leveraged ETF that seeks to double the return of the index starts at $100. If the index drops by 10 points on Day 1, it has a 10 percent loss and a resulting value of 90. Assuming it achieved its stated objective, the leveraged ETF would therefore drop 20 percent on that day and have an ending value of $80.
On Day 2, if the index rises 10 percent, the index value increases to 99. For the ETF, its value for Day 2 would rise by 20 percent, which means the ETF would have a value of $96. On both days, the leveraged ETF did exactly what it was supposed to do—it produced daily returns that were two times the daily index returns. But let’s look at the results over the 2-day period: the index lost 1 percent (it fell from 100 to 99) while the 2x leveraged ETF lost 4 percent (it fell from $100 to $96).
That means that over the two-day period, the ETF’s negative returns were 4 times as much as the two-day return of the index instead of 2 times the return.
FINRA Rule 2111: Suitability
FINRA Rule 2111 is a regulation established by the Financial Industry Regulatory Authority (FINRA), which governs the suitability of recommendations made by broker-dealers to their clients. This rule requires that any recommendations made by a broker-dealer must be suitable for the client based on the client’s investment profile, which includes their investment objectives, risk tolerance, financial situation, and other relevant factors.
In other words, the broker-dealer must ensure that any investment recommendations they make are suitable for the specific client they are working with, considering the client’s individual needs and circumstances.
For investors, this rule means that they can expect their broker-dealer to take into account their specific investment profile before making any recommendations. This can help investors make more informed investment decisions and avoid investments that may not be appropriate for their individual needs and circumstances. However, investors should still be aware of their own investment objectives, risk tolerance, and financial situation, and communicate them clearly to their broker-dealer to ensure that any recommendations they receive are appropriate for their needs.
FINRA Sanctions Involving Leveraged and Inverse ETFs
As you can see, non-traditional ETFs may not be suitable for many retail investors. In some cases, FINRA has issued sanctions against brokers and brokerage firms for failure to perform a reasonable basis suitability analysis.
In one example, in July 2021, FINRA reportedly suspended a financial advisor registered with Sanctuary Securities (formerly known as David A Noyes) for three-months and imposed a deferred fine of $5,000. FINRA also sanctioned the firm in May 2021 for several violations, including the failure to establish, maintain and enforce a supervisory system designed to meet FINRAs suitability standards for non-traditional ETFs. The firm was fined $160,000 and ordered to pay customer restitution of $370,161.
In May 2012, FINRA sanctioned four firms $9.1 Million for sales of leveraged and inverse exchange-traded funds. The regulator sanctioned Citigroup Global Markets, Inc; Morgan Stanley & Co., LLC; UBS Financial Services; and Wells Fargo Advisors, LLC a total of more than $9.1 million for selling leveraged and inverse exchange-traded funds (ETFs) without reasonable supervision and for not having a reasonable basis for recommending the securities. The firms were fined more than $7.3 million and are required to pay a total of $1.8 million in restitution to certain customers who made unsuitable leveraged and inverse ETF purchases.
Before Investing in Leveraged or Inverse ETFs
The best form of investor protection is to clearly understand leveraged or inverse ETFs before investing in them. No matter how you initially hear about them, it’s important to read the prospectus, which provides detailed information related to the ETFs’ investment objectives, principal investment strategies, risks, and costs. The SEC’s EDGAR system, as well as search engines, can help you locate a specific ETF prospectus. You can also find the prospectuses on the websites of the financial firms that issue a given ETF, as well as through your broker.
Make sure that your investment professional understands your investment objectives and tolerance for risk. Your investment professional should understand these complex products, be able to explain whether or how they fit with your objectives and be willing to monitor your investment.
Questions to Ask:
Before investing in these instruments, ask:
- How does the ETF achieve its stated objectives? And what are the risks? Ask about—and be sure you understand—the techniques the ETF uses to achieve its goals. For example, engaging in short sales and using swaps, futures contracts, and other derivatives can expose the ETF—and by extension ETF investors—to a host of risks.
- What happens if I hold longer than one trading day? While there may be trading and hedging strategies that justify holding these investments longer than a day, buy-and-hold investors with an intermediate or long-term time horizon should carefully consider whether these ETFs are appropriate for their portfolio. As discussed above, because leveraged and inverse ETFs reset each day, their performance can quickly diverge from the performance of the underlying index or benchmark. In other words, it is possible that you could suffer significant losses even if the long-term performance of the index showed a gain.
- Is there a risk that an ETF will not meet its stated daily objective? There is always a risk that not every leveraged or inverse ETF will meet its stated objective on any given trading day. Be sure you understand the impact an investment in the ETF could have on the performance of your portfolio, taking into consideration your goals and your tolerance for risk.
- What are the costs? Leveraged or inverse ETFs may be more costly than traditional ETFs. Use FINRA’s Fund Analyzer to estimate the impact of fees and expenses on your investment. The SEC’s Mutual Fund Cost Calculator can also help you estimate and compare the costs of owning mutual funds.
- What are the tax consequences? Leveraged or inverse ETFs may be less tax-efficient than traditional ETFs, in part because daily resets can cause the ETF to realize significant short-term capital gains that may not be offset by a loss. Be sure to check with your tax advisor about the consequences of investing in a leveraged or inverse ETF.
As with all investments, it pays to do your own homework. Only invest if you are confident the product can help you meet your investment objectives and you are knowledgeable and comfortable with the risks associated with these non-traditional ETFs.
Hiring a FINRA Attorney
Broker dealers are required to perform adequate due diligence on any investment they recommend and to ensure that all recommendations are suitable for the investor. Brokerage firms that fail to do so may be held responsible for any losses in a FINRA arbitration claim.
Experienced securities attorneys can help you through the FINRA arbitration process. The intricacies of FINRA arbitration can be challenging to navigate, and a skilled attorney with expertise in securities law can significantly enhance your prospects of a successful outcome.
If you are concerned about an investment in leveraged or inverse ETFs, or if you believe that you have been the victim of securities fraud, The White Law Group may be able to help. To speak to a securities attorney, please call our offices at 888-637-5510 for a free consultation.
The White Law Group is a national securities fraud, securities arbitration, investor protection, and securities regulation/compliance law firm with offices in Chicago, Illinois and Seattle, Washington.
For more information on The White Law Group, visit https://whitesecuritieslaw.com.
Tags: broker fraud, ETF's, Exchange-traded funds, FINRA, investment losses, investor protection, leveraged ETF, NASD, SEC, securities arbitration, Securities Attorney, Securities Lawyer Last modified: November 9, 2023