An Exchange traded fund (ETF) is a marketable security that tracks a selected benchmark or underlying investments. These products come in many different forms; an ETF could track an index, individual stocks, foreign currencies, certain sectors of the economy, bonds, commodities, or a complex basket of financial assets. Unlike mutual funds, ETFs trade on the market like a common stock.
Many investors want to know if ETFs are safe or risky investments. The answer is that it depends entirely on the structure of the specific ETF that you are considering. Ultimately, an exchange traded fund is only as safe as the benchmark or assets that it is tracking. For example, an ETF that is made up of a well-structured collection of investment grade corporate bonds will be far less risky than an ETF that is made up of speculative stocks.
There are other issues to consider as well. In recent years, brokers have increasingly recommended leveraged and inverse ETFs to investors. These are highly complex financial products that carry considerable additional risk. They are not appropriate for many retail investors. Here, our experienced investment fraud attorneys explain the most important things that you need to know about leveraged and inverse ETFs.
Leveraged and Inverse ETFs: The Basics
A leveraged ETF is designed to a deliver a return that is a multiple of the underlying index, benchmark, or assets that it tracks. For example, you may invest in a 2x leveraged ETF. The return on this product would be double that of the underlying investment. If you held 2X leveraged ETF that tracked the S&P 500, and the index gained 1 percent on a given day, then your ETF would be designed to gain 2 percent. Of course, this means that losses are amplified as well. If the S&P 500 lost 1 percent, your hypothetical ETF would lose 2 percent.
An inverse ETF is designed to deliver a return that is the direct opposite of the benchmark that it tracks. For example, if you invested in an inverse ETF, and the underlying assets or benchmark lost 2 percent of its value, then this ETF would gain 2 percent. Likewise, if the benchmark were to gain 2 percent, then your inverse ETF would be designed to lose 2 percent.
Leveraged and Inverse ETFs
A leveraged and inverse ETF combines both of the above listed qualities together into one financial product. Leveraged and inverse ETFs, also often referred to as ‘ultra short’ investments, are structured to deliver investors a return that is a multiple of the opposite of how the benchmark or underlying asset performs.
Warning: Leveraged and Inverse ETFs are Created to Be Held for a Single Day
While this may seem simple enough so far, it gets more complicated. One of the most important things that investors need to know about leveraged and inverse ETFs is that these financial products are almost always designed to be held for a single day.
If you hold these investments for any extended period of time, they are unlikely to directly track the underlying benchmark. The reason for this is relatively simple: a leveraged and inverse ETF needs to reset each day to ensure that it still tracks with its designed purpose. This means that after one day has passed, the ETF will no longer directly track the original benchmark.
Understanding the Single-Day Holding Period Through an Example
Imagine that an index has a value of 200. You purchase a 2X leveraged and inverse ETF to track this benchmark. On the first day, the index gains 10 percent, up to a value of 220. This means that your leveraged and inverse ETF has lost 20 percent of its value, and has dropped to a value of 160.
Instead of selling, you hold the leveraged and inverse ETF for a second day. On the second day, the index loses 10 percent, dropping down from 220 to a value of 198. This means that your leveraged and inverse ETF gained 20 percent, rising from a value of 160 to 192.
In the above example, the leveraged an inverse ETF performed to its design: it delivered the investor (you) a multiple of the inverse of the index, on a daily basis. Yet, over a two-day holding period, the total index lost one percent of its value, and yet your leveraged and inverse ETF actually lost money too, even though the index went down.
In other words, your investment would have lost four percent of its value. Over a two-day holding period, this ETF would have failed to deliver the correct multiple and the correct direction. The bottom line is simple: these financial products should only be held for a single day.
Leveraged and Inverse ETFs are Not Suitable for All Investors
Leveraged and inverse exchange traded funds are notoriously complex financial products. Most retail investors should not hold these types of ETFs. Further, your financial advisor should not push you into an investment that is not appropriate for your individual needs. Before purchasing a leveraged and inverse ETF, you should carefully consider:
- Your overall investment objectives;
- Your personal risk tolerance;
- Your understanding of the financial product; and
- The potential tax consequences of day-to-day trading.
In the event that you lost money in a leveraged and inverse ETF, and you believe that you should never have been invested in the product in the first place, your financial advisor may be responsible for your losses. You should consult with an experienced unsuitable investment attorney as soon as possible. Your lawyer will be able to assess your claim.
Did You Lose Money Investing in an Unsuitable ETF?
Our legal team help. At Sonn Law Group, our professional investor advocates have deep experience handling claims involving leveraged and inverse ETFs. If you lost a substantial amount of money investing in an unsuitable ETF, we are here for you. Please call our law firm today to schedule a free review of your claim.