What are traditional and non-traditional ETFs?

Exchange traded funds (ETFs) are pooled investments that work a lot like mutual funds. They track a particular index, market, or asset, and are purchased or sold on a stock exchange like any other stock.  

A lot of research has shown that normal ETFs are smart investments for the average investor, because you can use them to gain with the market and reduce risk. Broad, market-based ETFs, like those that let you track the Dow Jones or S&P 500, let you buy into the stock market broadly rather than picking stocks or sectors. These ETFs also have super-low expenses, charging just a fraction of one percent.

But non-traditional ETFs are different. They are riskier, more complicated, and mostly unwise for buy-and-hold investors.

Non-traditional ETFs have several downsides: they use complex strategies, come with high fees, and aren’t usually meant to be held more than one trading session.

Despite all these downsides to non-traditional ETFs, some financial advisors may encourage you to invest in them. Why? Because they may come with higher fees for the manager.

Financial regulatory agencies such as the Securities and Exchange Commission (S.E.C.) and Financial Industry Regulatory Authority (FINRA) have cautioned against using them.

And in some cases, regulators have imposed tough sanctions against brokerage firms that have recommended them to their retail customers:

Despite this, non-traditional ETFs have risen in popularity, leaving many losers in their wake.

Leveraged ETFs increase the ups—and the downs

One type of non-traditional ETF is the leveraged ETF. A leveraged ETF tries to deliver multiples of the daily performance of the index or benchmark that it tracks. 

Leveraged ETFs are designed for sophisticated, active traders and institutional investors who are comfortable with a lot of risk. They are a poor fit for the vast majority of buy-and-hold investors who are trying to build wealth.

Here’s how they generally work: If the underlying asset, such as the S&P 500, goes up for the day, the investor might get multiples of an increase. But if it goes down, the investor with a leveraged ETF will lose a lot more as well. Leveraged ETFs do this by buying underlying risky financial products such as derivatives, futures, and options.

Inverse ETFs work in the opposite direction of an index.

Inverse ETFs do the inverse of whatever the underlying index does. If the underlying index rises, then the inverse ETF falls in value, and vice versa.

Financial advisors will market inverse ETFs as a way for investors to profit from downward-moving markets. The problem with this is that, like the rest of us, financial advisors don’t know if the market will go up or down in the short term. And if they bet wrong, you stand to lose multiples of what you otherwise would have.

As with leveraged ETFs, the main purpose of these ETFs is for short-term trading rather than long term investing.

Inversed and leveraged ETFs.

Some non-traditional ETFs are both inverse and leveraged, meaning that they seek a return that is a multiple of the inverse performance of the underlying index.

Leveraged and inverse ETFs use a range of investment strategies, including swaps, futures contracts, and other derivative instruments. But these financial instruments can be inherently risky–remember the term “credit default swaps” from the 2007-08 financial crisis?

Non-traditional ETFs can reset every single trading session.

Non-traditional ETFs are not usually meant to be held long term. That is because many of them reset every trading session because they are intended to achieve their stated objective every single day. They are poor medium-term or long-term investments.

Even if they are sometimes work as part of a sophisticated trading strategy that will be closely monitored by a financial professional, they come with hefty fees. These fees can be much higher than regular ETFs.

Only short-term traders who plan on selling their shares within a few days of buying them should be investing in non-traditional ETFs.

Some non-traditional ETFs trade just one stock.

When you invest in an ETF, you expect it to be diversified. That was the whole idea behind the development of an exchange-traded fund. But some non-traditional ETFs trade just one stock and often both on a leveraged and inverse basis.

These single-stock ETFs are relatively new financial products.

Non-traditional ETFs can come with high fees.

They can also come with fees that are much higher than what an ETF or index fund that tracks the market charges. High fees slowly eat away at your investment account. And in the era of super-low-cost ETFs and mutual funds, it makes little sense for most long-term investors to pay these higher fees.

Check out FINRA’s Fund Analyzer to estimate the impact of fees and expenses on your investment. The SEC’s Mutual Fund Cost Calculator can also help you estimate and compare costs of owning mutual funds.

The SEC and FINRA both warn against non-traditional ETFs.

Both FINRA and the SEC have cautioned investors about the risks of using non-traditional ETFs. At a minimum, investors should ask the following before investing:

• What happens if I hold it longer than one trading day? Leveraged and inverse ETFs reset every day, meaning that their performance can lag over time. You could suffer significant losses even if the long-term performance of the index showed a gain.

• How does the ETF achieve its objectives? Ask about—and be sure you understand—how ETF uses to achieve its goals. For example, engaging in short sales and using swaps, futures contracts, and other derivatives can expose ETF investors to a host of risks.

• What are the costs? Leveraged or inverse ETFs may be more costly than traditional ETFs.

• What are the tax consequences? Leveraged or inverse ETFs may be less tax-efficient than traditional ETFs, in part because daily resets can cause the ETF to realize significant short-term capital gains that may not be offset by a loss. Be sure to check with your tax advisor about the consequences of investing in a leveraged or inverse ETF.

If your advisor mismanaged your account with non-traditional ETFs, let us know.

Did your advisor recommend a non-traditional ETF to you? Were you given false promises about how a non-traditional ETF would perform? You can always get a free consulation at Wilkowski Law for any potential claims you may have. Contact us for more information.