Exchange-traded funds (ETFs) are mutual fund-like registered investment companies whose shares trade on a securities exchange.
ETF shares typically trade throughout the day at prices established by the market, just like common stock issuances.
ETFs can provide investors with a liquid, low-cost, and tax-efficient way to achieve returns similar to a diversified stock index such as the S&P 500 and the Russell 2000.
However, ETFs have become more complex in recent years. Wall Street, in its efforts to generate more profits, has created numerous ETFs that utilize leverage and focus on narrower market sectors, which increases risk for investors.
Therefore, investors considering ETFs should evaluate each ETF investment individually and not assume all ETFs are alike.
Two types of ETFs that pose a significant risk to investors’ portfolios are leveraged and inverse leveraged funds.
Leverage is a technique used in the financial industry to multiply investment gains by using borrowed money. If, however, an investment is generating losses, money can be lost at a multiple rate due to the amount of money owed.
Leveraged ETFs seek to deliver multiples of the performance of an index by using borrowed funds. Inverse leverage funds also use borrowed funds to achieve multiples of the opposite of the movement of an index by employing a range of investment strategies such as swaps, futures contracts, and other derivative investments.
Thus, leveraged and inverse leverage funds can lose many times their value in a single day, which could ultimately lead to significant losses for investors.
ETFs that focus on narrower market sectors are known as Niche ETFs, which pose risks that are not typically explained to investors.
Some of the risks associated with investing in Niche ETFs include:
Closure – Niche ETFs rarely attract enough capital to make them profitable for their mangers, and they are oftentimes closed because of this. As a result, investors may incur losses or develop tax liabilities on any gains.
Illiquidity – Since Niche ETFs are thinly traded, they are illiquid. Consequently, they are more vulnerable to price volatility and market manipulation.
Overconcentration – Niche ETF brokers are pushing speculative investments based on hot trends. This investment strategy coupled with a focus on narrower market sectors will result in an under-diversified portfolio for investors. Niche ETFs should be limited to a portion of a well-diversified ETF portfolio, but only after an investor has been qualified.
Fees – Niche ETFs usually have hidden costs such as a differential between the purchase price and the sale price as well as a commission for the transaction.
There are several measures investors can take to protect themselves against the risks associate with investing in ETFs.
By reading the prospectus, investors will get detailed information related to an ETF’s investment objectives, investment strategies, risks, and costs. The Securities and Exchange Commission’s (SEC) EDGAR system, as well as online search engines, can help locate a specific ETF’s prospectus.
Prospectuses are also available on the websites of the financial firms that issue a given ETF, as well as through the broker-dealer offering the ETF.
Investors should also consider seeking the advice of an investment professional who takes into consideration each individual client’s investment objectives and tolerance for risk.
The investment professional should understand the complexity of the product, be able to explain whether or how it meets an investor’s objectives, and be willing to actively monitor the investment.
In addition, investors should consider the following before making an investment decision:
The stated objective might be relying on a risky strategy – Understand the techniques the ETF uses to achieve its goals will help avoid a host of risks.
For example, engaging in short sales and using swaps, futures contracts, and other derivatives can expose the ETF, and ETF investors, to significant losses.
The problem with buying and holding – While there may be trading and hedging strategies that justify holding leveraged and inverse leveraged ETFs 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.
Because leveraged ETFs “reset” every day, meaning that they are designed to achieve their stated objectives on a daily basis, it is possible to suffer significant losses even if the long-term performance of the index showed a gain.
Risks that threaten the ETF’s stated daily objective – There is always a risk that not every leveraged or inverse leveraged ETF will meet its stated objective on any given trading day.
Understanding the negative impact an ETF could have on returns while considering goals and tolerance for risk will help optimize portfolio performance.
Verify the costs – Leveraged or inverse leveraged ETFs may be more costly than traditional ETFs. Investors can use FINRA’s Fund Analyzer to estimate the impact of fees and expenses on an investment. The SEC’s Mutual Fund Cost Calculator can also help estimate and compare costs of owning funds.
Understand the tax consequences – Leveraged or inverse leveraged ETFs may be less tax-efficient than traditional ETFs because daily resets can cause the ETFs to realize significant short-term capital gains that may not be offset by a loss.
Prior to investing, it would be best to consult a tax advisor about the consequences of investing in leveraged or inverse leveraged ETFs.
The most important of investors’ rights is the right to be informed! This article on exchange-traded funds is by the Law Offices of Robert Wayne Pearce, P.A. , located in Boca Raton, Florida.
For over 40 years, Attorney Pearce has tried, arbitrated, and mediated hundreds of disputes involving complex securities, commodities and investment law issues.
The lawyers at our law firm are devoted to protecting investors’ rights throughout the United States and internationally!
Please visit our blog, post a comment, call 800-732-2889, or email Mr. Pearce at pearce@rwpearce.com for answers to any of your questions about losses you may have suffered in exchange-traded funds and/or any related matter.
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