Investors: Beware of ETFs

Investors need to understand Exchange Traded Funds–”ETFs”–before they jump in thinking they are just like mutual funds. Your broker or adviser may have pitched the product to you already. It’s the hottest thing on the Street, and that means investors need to be wary.

In 2008, many investors betting on a market downturn flocked to “inverse” and “leveraged” funds. An inverse ETF is designed to return the inverse–or opposite–of whatever index or benchmark it tracks. A leveraged ETF is designed to return a multiple of the daily performance of the index or benchmark it tracks.

Smart call, right? Think again. These investors got burned when the funds did not perform as promised due to volatility, the use of leverage and other factors that were not properly disclosed by the funds. Simply put, investors can get hammered by using a buy-and-hold strategy for these products, even if the benchmark rises or falls just as the investor predicted over time.

In fact, leveraged and inverse exchange traded funds are high on the state securities regulators’ watch list of “investor traps.”

Last year was the first time that the state securities regulators included ETFs on its top-10 list of investor concerns. The North American Securities Administrators Association–NASAA–said that one worry about ETFs is that they’ve become very mainstream. Regulators’ concerns were specifically related to complaints about leveraged and inverse ETFs.

Inverse ETFs are built by using derivatives to construct a security that profits from a decline in the underlying index or benchmark. (If you’ve been a reader of this blog, you know that any time the word “derivative” is linked to an investment product for a mom-and-pop retail investor, disaster often follows.)

Recently, we have also seen cases of brokers “churning”–meaning frequently, needlessly trading–ETFs in clients’ accounts to generate outsize commissions.

Regulators have even commented that brokers and advisers may not understand fully how the leveraged or inverse ETFs work.

Investors: Beware of ETFs.

About Jacob H. Zamansky 57 Articles

Jacob (”Jake”) H. Zamansky is one of the country’s foremost authorities on securities arbitration law, the legal recourse for investors claiming broker wrongdoing, or for brokers claiming wrongful termination or other misconduct by their employer. Zamansky & Associates, the New York-based law firm he founded, represents both individuals and institutions in complex securities, hedge fund, and employment arbitrations.

Mr. Zamansky was at the forefront of recent efforts to “clean up” Wall Street. In 2001, he successfully sued former Merrill Lynch analyst Henry Blodget on behalf of a New York pediatrician misled by Blodget’s stock research. The case’s successful resolution was the catalyst for New York Attorney General Elliot Spitzer to investigate the conflicts of interest on Wall Street and resulted in the well-reported $1.4 billion Global Settlement, which included many of the biggest names on Wall Street.

More recently, Mr. Zamansky is one of the leading litigators and opinion leaders of the subprime mortgage crisis and the related hedge fund collapses, representing both investors and mortgage borrowers who were defrauded by Wall Street firms and mortgage lenders. Among Mr. Zamansky’s early actions is filing the first arbitration case on behalf of institutional and high net worth investors against Bear Stearns Asset Management with regard to the two hedge funds which collapsed as a result of exposure to subprime mortgage backed securities. He also has filed claims on behalf of individual investors victimized by brokers that steered their portfolios into unsuitable subprime stocks and mortgage borrowers who were fraudulently coerced into inappropriate mortgage and investment transactions.

Earlier in his career, Mr. Zamansky worked for more than 30 years as a litigator, including positions at Skadden Arps, Slate, Meagher and Flom LLP. His tenure also included serving as a federal prosecutor with the Federal Trade Commission.

A native of Philadelphia, Mr. Zamansky has been a frequent expert commentator on CNBC, CNN, and FOX News and has published opinion pieces in The Wall Street Journal, Financial Times and USA Today. He is regularly quoted and his cases have been chronicled in major financial and news publications including The New York Times, USA Today, The Washington Post, BusinessWeek, Fortune and Forbes. He is a frequent lecturer for industry and legal groups around the country. He also writes a blog that can be viewed here.

Visit: Zamansky & Associates

1 Comment on Investors: Beware of ETFs

  1. Oh of heaven’s sake. We are not dumb and we know leverage when we see it. (Margined brokerage accounts, for example). DIA and SPY are safer equity investments than the latest stocks your broker is pushing. They are great for buy-and-hold investors who are looking for a basket of U.S. companies that have global reach: Caterpillar, Intel, Chevron, etc.

    Disclosure: I am long in DIA

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