Exchange-Traded Funds (ETFs)

Exchange-traded funds (ETFs) are funds that trade on a stock exchange. ETFs own a bundle of assets such as stocks or bonds, and investors in an ETF can buy or sell shares in the ETF, as they would any other publicly traded stock.

ETFs often seek long-term capital growth and track a specific market index. As such, ETFs are attractive to investors because they offer an interest in a diversified portfolio of professionally managed investments.

ETFs calculate the net asset value (NAV) of their portfolios at the end of each trading day. The NAV calculation comes from the total value of all the securities in the fund portfolio, any fund liabilities, and the number of outstanding shares in the fund.

Traditional ETFs v. Non-Traditional ETFs

Non-traditional ETFs can be risky and highly complex products.

Unlike traditional ETFs, non-traditional ETFs such as leveraged and inverse ETFs typically use custom-built indexes designed to return a multiple of an underlying index or benchmark, the inverse of that benchmark, or both, usually in one trading session (i.e., a single day).

Non-traditional ETFs are generally not suitable for retail investors planning to hold them for more than one trading session, as the funds go through a “daily reset” and rebalance their portfolios daily.

Moreover, because of the effect of compounding during the holding period, the performance of non-traditional ETFs over periods longer than a single trading session can differ significantly from the performance of their underlying index or benchmark during the same time period.

Common FINRA Issues Involving Non-Traditional ETFs

Many brokerage firms and stockbrokers do not fully understand non-traditional ETFs and improperly recommend them to retail customers as intermediate or long-term, buy-and-hold investments. These unsuitable recommendations often lead to irreplaceable investment losses for customers, particularly those with conservative investment objectives and risk profiles.

Additionally, brokers repeatedly fail to adequately explain the risks associated with non-traditional ETFs, resulting in misrepresentations and omissions about their risks and nature.

Other misconduct involves sales practices violations, including firms without adequate supervisory systems to monitor the sale of leveraged and inverse ETFs or firms failing to conduct adequate due diligence regarding the risks and features of the ETFs.

In fact, in the past, FINRA has sanctioned firms for selling leveraged and inverse ETFs without reasonable supervision and without having a reasonable basis for recommending the securities.

FINRA has issued guidance to brokerage firms and registered representatives about their sales practice obligations through Regulatory Notice 09-31. The FINRA Notice makes clear that broker-dealers “must understand the terms and features of the funds, including how they are designed to perform, how they achieve that objective and the impact that market volatility, the ETF’s use of leverage, and the customer’s intended holding period will have on their performance.”

A Note on Leveraged and Inverse ETFs

Leveraged ETFs notoriously use derivatives or futures to double or triple an index’s return.

Inverse leveraged ETFs seek to return double or triple the opposite of the return of the index. In other words, a 3X inverse leveraged ETF seeks to achieve growth of 30% when an index declines by 10%. Over holding periods longer than a day, the compounding effect of leveraged ETFs can lead to results that vary significantly from the one-day outcome. As a result, they are highly risky and unpredictable to hold for more than one day.

Both products are designed for short-term trading rather than for long-term investors. They are typically not suitable for retail investors who plan to hold them for more than a single trading session.

Other ETF Considerations

An investor who buys or sells shares in an ETF will generally pay a commission on each transaction.

ETFs also have expense ratios – the annual fee – that ETFs charge their shareholders, and which is calculated as a percentage of the assets the investor has invested. However, ETFs do not have loads or the 12b-1 fees charged by mutual funds to cover costs associated with marketing, advertising, and distributing the fund to investors.

Investors should review the ETF’s prospectus to understand the ETF’s costs and how the ETF is structured.

If you have suffered losses investing in traditional ETFs or non-traditional ETFs such as leveraged and inverse ETFs, Iorio Altamirano LLP can analyze your claim and losses, negotiate with the company, and pursue your claim in arbitration if necessary.

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