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.
Leveraged and Inverse ETFs
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.
Uses and Abuses of Nontraditional ETFs
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.
Because of their complexity, non-traditional ETFs are very often misused by brokers and financial advisors, and have come under scrutiny by FINRA and the SEC. Both regulatory bodies have issued warnings and guidelines for appropriate use of leveraged and inverse ETFs. For more information, please visit the SEC or FINRA’s FAQ page on the product.
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