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.
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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