A U.S. Senate banking subcommittee is starting hearings today on the structure and market impact of exchange traded funds. As referenced in the Wall Street Journal article, “ETFs on the Hot Seat,” they are intensely controversial alternative investments. This is especially true of the high-risk synthetic, leveraged and niche exchange traded funds that have proliferated in recent years. These securities have increased market volatility and portfolio risk for many unsuspecting investors.
Synthetic exchange traded funds hold derivatives (option and swap contracts) linked to the asset they purport to track, but do not hold the asset itself. Most investors and brokers do not have a sufficient understanding of these investments.
Leveraged exchange traded funds seek to multiply the performance of an underlying asset by the use of borrowed funds (i.e., leverage). Inverse leveraged funds seek to multiply leveraged short positions on the underlying asset. The funds are not meant for ordinary investors but are day-trading vehicles that can actually move in the opposite direction from their reference assets.
Niche exchange traded funds are extremely concentrated (i.e., not diversified) bundles of often illiquid assets that may be otherwise difficult or impossible for most investors to buy. While niche ETFs can function as a hedge against certain risks and enhance a diversification of a portfolio in small doses, too often they are sold and used for speculation rather than diversification.
John Bogle, who founded Vanguard and invented index investing, said: “Diversification is not only the first important thing investors should think about, but the second and the third, and probably the fourth and fifth, too.” That is also something that sales agents should consider, since they are required by law not to recommend any investment without reasonable grounds to believe that it is suitable for the customer based on his or her investment objectives, risk tolerance, and other personal and financial information.
We will follow the Senate hearings with interest.
Page Perry is an Atlanta-based law firm with over 150 years collective experience representing investors in exchange traded fund (ETF) litigation and arbitration. While past results are not indicative of future success, Page Perry’s attorneys have recovered over $1,000,000 for clients on more than 45 occasions. For further information, please contact us.