Non-Traditional ETFs, Popular and Perilous

News of the perils for retail investors of the complex financial products known as non-traditional ETFs has been fast and furious this year. This shouldn’t be too surprising. Non-traditional ETFs are the “it” investment these days: they have continued to grow in popularity, with their largest year-end proportion ever in 2013. According to Morningstar reporting, these exotic funds now account for 13.2% of all fund assets as of November. If you’re not familiar with non-traditional ETFs, chances are you will be soon: their popularity, in spite of several high profile lawsuits related to inappropriate use and unsuitability claims, seems unstoppable. The latest lawsuit involves a broker-dealer called “Stifel Financial Corporation.” According to a recent article, the securities industry watchdog FINRA (Financial Industry Regulatory Authority), fined and censured Stifel Nicolaus and Century Securities $550,000 and ordered restitution payments of $475,000 to a combined more than 60 customers for misconduct related to the recommendation and sale of leveraged and inverse ETFs.

photo by Katrina.Tuliao, Creative Commons

And it’s happening all the time.

For the very simple reason that far too many brokers who recommend and sell non-traditional ETFs to customers do not understand how they work. And their brokerage firms do not educate and/or supervise these brokers adequately.

FINRA’s crackdown on offenses connected to non-traditional ETFs is good news for investors whose portfolios have been damaged by these products and their improper use by clueless brokers.

Now, we’ve already said a lot about the havoc non-traditional ETFs have wreaked--but what are they?

Well, since you asked… Non-traditional ETFs are complex financial products designed to achieve specific performance results on a daily basis. An ETF or “Exchange-Traded Fund” is typically a registered investment company whose shares represent an interest in a portfolio of securities that are linked to a specific benchmark or index. (Some ETFs, for example, those invested in commodities or currencies, may not however be registered). ETFs are funds, but unlike traditional mutual funds, they are traded throughout the day on a securities exchange at market prices.

Non-traditional ETFs include both leveraged and inverse ETFs as well as leveraged inverse ETFs. Leveraged ETFs aim to deliver multiples of the performances of the underlying index or benchmark that the fund is tracking. Inverse ETFs or “short funds” on the other hand deliver the opposite of the index or benchmark. Some ETFs are both leveraged and inverse, in which case they combine qualities from both categories of ETFs, hoping to deliver multiples on the inverse of the performance of the index or benchmark. These are called “leveraged inverse ETFs” or “ultra-short funds.” To achieve results, non-traditional ETFs deploy various investment strategies that include swaps, futures contracts, and other derivative instruments. Again, and most crucially, both leveraged and inverse ETFs are designed to give results on a daily basis only.

On a daily basis, non-traditional ETFs “reset.” This key characteristic of the product is the one most often misunderstood or misapplied by investors and professional financial advisors alike. Since leveraged and inverse ETFs are intended for daily use only, holding shares in them for longer-term investment can be dangerous due to the effects of compounding, particularly in volatile markets. Non-traditional ETFs can be an effective means of trading and shorting within a complex investment strategy when closely monitored by a financial professional. However, they  are typically not suitable for intermediate or long-term investment and any financial advisor who uses them in this way may be guilty of misconduct and/or unsuitability.

If you’ve gotten this far, you now probably know more than most brokers about how this product works.

If you or anyone you know has been the victim of broker misconduct or investment fraud, please contact us immediately at 1-855-462-3330.

Brokerage Fined $700,000+ for Misuse of Non-Traditional ETFs

The Financial Industry Regulatory Authority (FINRA) recently announced that it has fined Atlanta-based brokerage firm J.P. Turner & Company, L.L.C. more than $700,000 for the alleged misuse and unsuitable recommendation and sale of complex securities products called non-traditional ETFs to customers who had no business holding these products. According to FINRA’s press release, JP Turner brokers also allegedly engaged in excessive mutual fund switches, which involves using mutual fund products designed for long-term use on a short-term basis in order to generate illegitimate trading fees.

In our many successful cases dealing with customers who have suffered losses due to the misuse and abuse of non-traditional ETFs, we have found that investors rarely understand what a non-traditional ETF actually is or how it works. What’s more, very few brokers actually understand non-traditional ETFs! Which is probably why in 2009 FINRA also issued one of its regular “Investor Alerts” about perils of investing in non-traditional ETFs--for brokers and clients.

Photo by Rafael Matsunaga, Creative Commons

Traditional ETFs are defined by FINRA as “registered investment companies whose shares represent an interest in a portfolio of securities that track an underlying benchmark or index.” Non-traditional ETFs like those at issue in the case against J.P. Turner & Company generally come in two forms: leveraged and inverse. Leveraged ETFs offer returns at a multiple (often 2X or 3X) whatever benchmark they track. Inverse ETFs act the way they sound: they offer returns at an inverse multiple of the benchmark. If you benchmark falls, you win; and vice versa. If you’re already a little confused, don’t worry: so apparently are the thousands of financial advisors out there recommending and misusing these products. Not to add the confusion, but...

There’s one other aspect of these complex products that is absolutely crucial to understanding them: they “reset” daily. That means that they are only effective one day at a time and should not be held in investor accounts for any longer than that. According to FINRA, JP Turner’s brokers failed to grasp this unique quality of non-traditional ETFs held the ETFs for not a day, days or weeks--but months at a time!

For more information about non-traditional ETFs, please click here.

If you or anyone you know has been the victim of the misuse of non-traditional ETFs or any other form of broker misconduct or investment fraud, please contact us immediately toll-free at 1-855-462-3330 for a free consultation.