Exchange-Traded Funds: Benefits and Risks of the Popular Investment Vehicle

Exchange-traded funds, or ETFs, are investment products that can have a great deal of utility 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 are widely utilized and can be a very useful investment product, many brokers and investors do not understand the products. If you need a complete review of the terms and features of an ETF or have questions about the ETF recommended to you by your stockbroker or brokerage firm, experienced securities law attorneys are the best resource at your disposal. But, a general understanding of the pros and cons of ETFs can benefit investors.

ETF Overview

As defined by New York Stock Exchange regulations, an exchange-traded fund is an investment vehicle that allows an investor to buy and sell shares in a single security that represent a fractional ownership of a portfolio of securities. This portfolio of securities typically tracks an underlying benchmark or index – for instance, the first ETF ever listed was meant to replicate the performance of the S&P 500 index. ETFs are structured similarly to mutual funds. Unlike mutual funds, however, shares of ETFs can be bought and sold throughout the trading day, much like common stocks.

So called “non-traditional” ETFs are a more specialized ETF subset that are growing in both number and popularity. Yet, despite their proliferation, non-traditional ETFs are one of the greatest sources of confusion and problems for ETF investors.

The two primary types of non-traditional ETFs are leveraged and inverse ETFs. Leveraged 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 in hybridized leveraged inverse ETFs, which are also called “ultra short” funds ( e.g., seeking a return of 2x or 3x the opposite of the benchmark).

The major stumbling block many investors face when investing in leveraged or inverse ETFs is getting a solid grasp on the fact that these funds are typically designed to achieve their stated performance on a daily basis. In other words, leveraged or inverse ETFs are not designed to match the return of their underlying benchmark or index for a holding period that is longer than the objective stated in the prospectus (generally one day). Yet, many brokers do not understand these products and mistakenly sell them to investors as long-term buy-and-hold securities, much like a mutual fund.

But the compounded return of a leveraged ETF or inverse ETF 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. This potential discord between daily investment objectives and long-term goals can be exacerbated by volatile markets. As a result, investors in leveraged 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 products to the investor.

ETFs Have Many Advantages, But Detractors Recommend Caution

Proponents argue that ETFs are an ideal investment tool in today’s volatile markets. For one thing, ETFs may be traded rapidly to reflect market swings. In addition, the broad range of available ETFs allows investors to allocate their resources in a very specific, targeted manner. And, in a stagnant or downward market, there is obvious appeal in inverse ETFs. But because ETFs generally are designed to track only the daily performance of the related index, it is crucial that brokers and investors monitor their ETF investments on a daily basis. The failure to do so can lead to devastating investment losses. Treating ETFs as long-term, buy-and-hold investments can be a recipe for financial disaster.

Of course, like any investment, the value of an ETF may decline due to market conditions. But, ETFs also have certain unique risks built into their structure. For instance, while ETFs are meant to provide investment results that correspond to the price and yield performance of their tracked underlying indexes, trust expenses and other factors mean that ETFs do not always achieve the desired mirroring effect (this is known as “tracking error”). Leveraged and inverse ETFs, in addition to being more volatile than standard ETFs, may include extra fees and fund expenses, and can also be less tax efficient than their traditional counterparts. Finally, ETFs may not belong in the portfolios of many long-term investors at all, and their complexity makes them more suited to professional traders.

A Keener Understanding of Your Rights

Most of us with investable assets rely on the services of a professional brokerage firm to help guide our long-term strategy. 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 stock broker 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 are required to follow in the performance of their professional duties. Among other things, before recommending the purchase, sale, or exchange of 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 to whom it is recommended. False, exaggerated, or misleading statements are also prohibited; data presented about ETFs must present a fair and balanced picture of both the potential risks and benefits of the securities.

Violation of a FINRA rule does not necessarily give rise to a legal cause of action against a stockbroker. But, it can be a good indicator that your rights as an investor have been violated. 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.