Leveraged and Inverse ETFs: Specialized Products with Extra Risks for Buy-and-Hold Investors The SEC staff and FINRA are issuing this Alert because we believe individual investors may be confused about the performance objectives of leveraged and inverse exchange-traded funds (ETFs). Leveraged and inverse ETFs typically are designed to achieve their stated performance objectives on a daily basis. Some investors might invest in these ETFs with the expectation that the ETFs may meet their stated daily performance objectives over the long term as well. Investors should be aware that performance of these ETFs over a period longer than one day can differ significantly from their stated daily performance objectives.

What Are Exchange-Traded Funds?

ETFs are typically registered investment companies whose shares represent an interest in a portfolio of securities that track an underlying benchmark or index. (Some ETFs that invest in commodities, currencies, or commodity- or currency-based instruments are not registered as investment companies.) Unlike traditional mutual funds, shares of ETFs typically trade throughout the day on a securities exchange at prices established by the market. ETFs have evolved over the years, becoming more complex. Investors considering ETFs should evaluate each investment closely and not assume all ETFs are alike. In the last few years, a number of leveraged and inverse ETFs have been introduced to the market that are very different from the traditional variety of ETFs.

What are Leveraged and Inverse ETFs?

Leveraged ETFs seek to deliver multiples of the performance of the index or benchmark they track. Inverse ETFs (also called “short” funds) seek to deliver the opposite of the performance of the index or benchmark they track. Like traditional ETFs, some leveraged and inverse ETFs track broad indices, some are sector-specific, and others are linked to commodities, currencies, or some other benchmark. Inverse ETFs often are marketed as a way for investors to profit from, or at least hedge their exposure to, downward moving markets. Leveraged inverse ETFs (also known as “ultra short” funds) seek to achieve a return that is a multiple of the inverse performance of the underlying index. An inverse ETF that tracks a particular index, for example, seeks to deliver the inverse of the performance of that index, while a 2x (two times) leveraged inverse ETF seeks to deliver double the opposite of that index’s performance. To accomplish their objectives, leveraged and inverse ETFs pursue a range of investment strategies through the use of swaps, futures contracts, and other derivative instruments.

Most leveraged and inverse ETFs “reset” daily, meaning that they are designed to achieve their stated objectives on a daily basis. Their performance over longer periods of time -- over weeks or 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. As the examples below demonstrate, an ETF that is set up to deliver twice the performance of a benchmark from the close of trading on Day 1 to the close of trading on Day 2 will not necessarily achieve that goal over weeks, months, or years.

Real-Life Examples

The following two real-life examples illustrate how returns on a leveraged or inverse ETF over longer periods can differ significantly from the performance (or inverse of the performance) of their underlying index or benchmark during the same period of time.

Between December 1, 2008, and April 30, 2009, a particular index gained 2 percent. However, a leveraged ETF seeking to deliver twice that index's daily return fell by 6 percent—and an inverse ETF seeking to deliver twice the inverse of the index's daily return fell by 25 percent.

During that same period, an ETF seeking to deliver three times the daily return of a different index fell 53 percent, while the underlying index actually gained around 8 percent. An ETF seeking to deliver three times the inverse of the index's daily return declined by 90 percent over the same period.

How can this apparent breakdown between longer term index returns and ETF returns happen? Here’s a hypothetical example: let’s say that on Day 1, an index starts with a value of 100 and a leveraged ETF that seeks to double the return of the index starts at $100. If the index drops by 10 points on Day 1, it has a 10 percent loss and a resulting value of 90. Assuming it achieved its stated objective, the leveraged ETF would therefore drop 20 percent on that day and have an ending value of $80. On Day 2, if the index rises 10 percent, the index value increases to 99. For the ETF, its value for Day 2 would rise by 20 percent, which means the ETF would have a value of $96. On both days, the leveraged ETF did exactly what it was supposed to do – it produced daily returns that were two times the daily index returns. But let’s look at the results over the 2 day period: the index lost 1 percent (it fell from 100 to 99) while the 2x leveraged ETF lost 4 percent (it fell from $100 to $96). That means that over the two day period, the ETF's negative returns were 4 times as much as the two-day return of the index instead of 2 times the return.

FINRA, SEC Warn Retail Investors About Investing in Leveraged or Inverse ETFs Washington, DC — The Financial Industry Regulatory Authority (FINRA) and the Securities and Exchange Commission (SEC) have issued an Investor Alert called Leveraged and Inverse ETFs: Specialized Products with Extra Risks for Buy-and-Hold Investors warning retail investors of the risks associated with investing in these highly complex financial products. This Investor Alert follows a recent FINRA Regulatory Notice reminding securities firms and brokers of their sales practice obligations relating to leveraged and inverse exchange-traded funds (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," said 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. This means that they are designed to achieve their stated objectives on a daily basis. 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. For example, between December 1, 2008, and April 30, 2009, a leveraged ETF seeking to deliver three times the daily return of the Russell 1000 Financial Services Index fell 53 percent, while the underlying index actually gained approximately 8 percent. A leveraged inverse ETF seeking to deliver three times the inverse of the Russell 1000 Financial Services Index's daily return declined by 90 percent 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 specialized ETFs. Because these products are complex and can be confusing, 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.

Leveraged and Inverse ETFs also includes a list of questions investors should ask to better understand the risks of investing in these financial products.

FINRA, the Financial Industry Regulatory Authority, is the largest independent regulator for all securities firms doing business in the United States. FINRA is dedicated to investor protection and market integrity through comprehensive regulation. FINRA touches virtually every aspect of the securities business — from registering and educating all industry participants to examining securities firms; writing and enforcing rules and the federal securities laws; informing and educating the investing public; providing trade reporting and other industry utilities; and administering the largest dispute resolution forum for investors and firms.

FIRMS BAN SALE OF HIGHLY LEVERAGED ETFs

Edward Jones announced that it was banning leveraged exchange traded funds (ETFs). Now two more names have jumped into the fray. LPL Financial said that they were banning the sale of ETFs that use more than 200% leverage, while Ameriprise said they were banning sales of all leveraged ETFs. The regulatory scrutiny of the products is making the brokers nervous. These announcements are coming after a warning from FINRA, which reminded firms of their obligation to investors when it comes to leveraged and inverse funds. These ETFs are typically viewed as unsuitable for long-term, buy-and-hold investors. Their providers have been very vocal about who these funds are intended for - tactical traders who are prepared to monitor their portfolios closely.

ETF's considered highly levered: SMN, DXO, SKF, SDS, UYG, FAZ, DUG, SDS, and others. If your broker sold you these securities in a long term portfolio please give us a call to discuss your case.