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Retail investors warned about leveraged and inverse ETFs

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The Financial Industry Regulatory Authority and the Securities and Exchange Commission have issued an investor alert warning retail investors of the risks associated with investing in l

The Financial Industry Regulatory Authority and the Securities and Exchange Commission have issued an investor alert warning retail investors of the risks associated with investing in leveraged and inverse exchange-traded funds.

The alert follows a recent Finra regulatory notice reminding securities firms and brokers of their sales practice obligations relating to leveraged and inverse ETFs.

Traditional ETFs are designed to track an index, such as the S&P 500, or the price of an individual asset. Leveraged ETFs seek to deliver multiples of the performance of the index or benchmark (such as commodities or currencies) they track. Inverse ETFs (also called short funds) seek to deliver the opposite of the performance of the index or benchmark they track and are often marketed as a way for investors to profit from, or at least hedge their exposure to, downward moving markets.

Both leveraged and inverse ETFs pursue a range of investment strategies through the use of swaps, futures contracts and other derivative instruments.

‘Not all ETFs are created equal,’ says John Gannon, Finra senior vice president for investor education. ‘Over time, leveraged and inverse ETFs can deviate substantially from the performance of the underlying benchmark, particularly in volatile periods. They are highly complex financial instruments that can turn into a minefield for buy-and-hold investors.’

Most leveraged and inverse ETFs reset daily. Their performance over longer periods of time – over weeks, months or years – can differ significantly from the performance (or inverse of the performance) of their underlying index or benchmark during the same period of time. This effect can be magnified in volatile markets.

Between 1 December 2008 and 30 April 2009, a leveraged ETF seeking to deliver three times the daily return of the Russell 1000 Financial Services Index fell 53 per cent, while the underlying index actually gained approximately eight per cent. A leveraged inverse ETF seeking to deliver three times the inverse of the Russell 1000 Financial Services Index’s daily return declined by 90 per cent over the same period.

The SEC and Finra are advising investors to consider leveraged and inverse ETFs only if they are confident the product can help meet their investment objectives and they are knowledgeable about and comfortable with the risks associated with these specialised ETFs. They say investors should consider seeking the advice of an investment professional who understands these products, can explain whether or how they fit with the individual investor’s objectives, and who is willing to monitor the specialized ETF’s performance for his or her customers.

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