ETFs (Exchange Traded Funds)

Exchange traded funds are mutual fund-like baskets of securities that trade like stocks. The growth of this alternative investment has been explosive. Over $1 trillion in assets was invested in exchange traded funds as of the end of 2010. Individual (retail) investors account for much of that growth.

The first exchange traded funds provided investors with a low-cost way to achieve exposure to a broadly diversified stock index like the S&P 500 Stock index and the Russell 2000 stock index. These and similar exchange traded funds have provided investors a relatively low-cost, tax-efficient and highly liquid vehicle for achieving the same return as a broadly diversified market index.

In recent years, however, Wall Street, in an effort to generate more revenue, has created countless exchange traded funds that focus on ever-narrower market sectors and slices of sectors (niche funds), as well as leveraged, inverse leveraged and synthetic exchange traded funds. These extreme and exotic funds have hidden risks that are dangerous for investors.

Niche exchange traded funds are narrowly focused on particular sectors and slices of sectors. Examples include the JETS Dow Jones Islamic Market International Index, Global X Fishing Industry Fund, Global X Farming ETF, Global X Fertilizer Fund, and the like. Niche exchange traded funds involve risks that are frequently not explained to investors. Those risks include:

  • Overconcentration – Sellers of niche exchange traded funds invite investors to speculate on supposedly hot trends. Speculation often leads to a concentrated rather than a balanced and diversified portfolio. Most investors should limit exchange traded fund holdings to broadly diversified funds, which may include the niche that interests them, but as an appropriate proportion of their overall portfolio.
  • Fees – These funds may have hidden costs, including a differential between the purchase price and the sale price, as well as transaction-based commissions.
  • Illiquidity – Niche exchange traded funds are thinly traded and illiquid. As a result, they are subject to greater price volatility and market manipulation.
  • Closure – Niche exchange traded funds often do not attract enough capital to make it profitable for the managers, who then close the fund. When an exchange traded fund closes, shareholders may incur losses or owe taxes on any gains.
  • Premium/Discount – Exchange traded funds trade like stocks with the result that they may be priced at a premium or a discount relative to the net asset value of the underlying holdings.

Leveraged and inverse leveraged funds suffer from all of the above risks, as well as other risks that make them even more dangerous. Leveraged exchange traded funds use borrowed funds to increase the potential upside and downside by a factor of two, three or more. Inverse leveraged funds also use leverage to achieve two or three times the opposite of the movement of the reference assets as part of a hedging or shorting strategy. Both are far more sensitive to market movements than non-leveraged exchange traded funds because of the multiplier effect of leverage. As a result, leveraged and inverse leveraged exchange traded funds can lose many times their value in a single day.

The Securities and Exchange Commission (SEC), the North American Securities Administrators Association (NASAA), and the Financial Industry Regulatory Authority (FINRA) have all recently cautioned that leveraged and inverse leveraged exchange traded funds are dangerous financial products that are unsuitable for most investors.

The most important thing for investors to realize is that leveraged and inverse leveraged exchange traded funds are NOT INTENDED TO BE “BUY AND HOLD” INVESTMENTS. They are designed for day-trading, an extraordinarily risky strategy. They use derivatives to achieve their objectives. Due to the effects of derivatives and daily compounding of returns, the long-term performance of leveraged and inverse leveraged exchange traded funds may be dramatically different from the benchmark. For example, FINRA has warned that a leveraged exchange traded fund that is supposed to return 200% of an index’s return can decline in value, even though the index rises. Indeed, ProShares UltraShort S&P 500 (SDS), which makes a double bet against the S&P 500, reportedly lost 40% in 2010 as the S&P 500 gained 13%.

Synthetic exchange traded funds are another high risk investment. They do not own the physical assets they track but use derivatives (options and swaps) to attempt to replicate the performance of those assets. The use of derivatives introduces lack of transparency, as well as the risk of tracking errors and counterparty risks (the other side of a derivatives transaction is an unsecured obligation of the counterparty, which may default on it). Those risks are not present when the exchange traded fund holds the physical assets. BlackRock, Inc., the dominant ETF firm that owns 42% of the ETF market, recently announced that it is moving away from synthetic exchange traded funds, and issued a report calling for increased transparency and regulation concerning them.

Extreme and exotic exchange traded funds are inappropriate for buy-and-hold investors. John Bogle, the founder of Vanguard and the creator of the first index mutual fund, said of them: “It’s insanity. This is a classic case of Wall Street trying to capitalize on the worst instincts of investors.”

Regulators are concerned that investors and sales agents do not understand the risks of extreme and exotic exchange traded funds. FINRA announced that it is focusing on abuses involving sales of exchange traded funds.

Investors should think twice before investing in extreme or exotic exchange traded funds.

If you have investment losses or problems involving ETFs (Exchange Traded Funds), call the lawyers at Page Perry for experienced representation at (770) 673-0047 or (877) 673-0047 (toll free).