The Business Of Law

It may be time to add exchange-traded funds (ETF) to the alphabet soup of culprits of the economic meltdown, and it may be that investors who lost money in ETF’s may have claims against the funds and/or their investment advisors.

ETFs offer public investors an undivided interest in a pool of securities and other assets and thus are similar in many ways to traditional mutual funds, except that shares in an ETF can be bought and sold throughout the day like stocks on a securities exchange through a broker-dealer. That of course makes them very different.

The fact that shares of an ETF can be traded daily on exchanges means they are vulnerable to the ups and downs of a given trading day, what’s more, many of these funds are leveraged, meaning they use borrowed money to try to double or even triple the daily return. The problem of course is that this leverage also means they can lose many times their underlying value, even in a single day.

With this in mind, it is generally recommended that ETF’s are most appropriate for sophisticated and institutional investors who are accustomed to the daily ups and downs of the market, and the increased risk that comes with leverage.

That’s where the trouble comes in. Since 2006 there has been increased marketing of these funds to conservative retail investors as long term investment vehicles. That’s a big problem, because the performance of ETFs over longer periods of time can differ significantly from their stated daily objective. Therefore, leveraged ETFs that are reset daily are typically unsuitable for retail investors who plan to hold them for longer than one trading session, particularly in volatile markets.

Leveraged ETFs in particular are more sensitive to market movements than non-leveraged ETFs. They are best used as day-trading vehicles, to be held no more than a day or two.

Both FINRA and the SEC have issued warnings in the last six months about the risks associated with the sale of ETFs to retail investors. ETFs are becoming extremely popular and are often marketed to retail investors without proper disclosure as to the significant losses that can incur with long-term investment.

The problem of marketing these risky products to retail investors has become so acute that regulators and investment advisors have started to warn consumers. In August, the SEC and FINRA issued an investor alert warning retail investors about the safety of leveraged ETFs calling them extremely complicated and confusing products.

Given the rapid growth of these funds, we expect there may be many investors who have suffered economic losses as a result of misleading marketing tactics. Many of these investors will likely have claims against their financial advisors and/or the funds or both.

If you are interested in learning more about this case-type and our work in this area, please drop me a note.