Information About Exchange-Traded Funds
Exchange-traded funds (ETFs) are SEC-registered investment vehicles that provide an opportunity for investors to purchase securities within an asset class or targeted sector of the economy. While ETFs are typically registered unit investment trusts or open-end investment companies, unlike traditional unit investment trusts or mutual funds which are priced a single time daily, shares of ETFs are generally traded throughout the day on an exchange at prices established by the market in a similar manner to individual stocks. ETF shares generally represent an interest in a portfolio of securities that tracks an underlying benchmark or index, such as the Standard & Poor’s 500 Index. Some ETFs track broad indices, some are sector-specific, and others are linked to commodities, currencies, or some other benchmark.
While these products represent alternatives to other investments such as individual stocks or mutual funds, it is important that you fully understand the complex nature of these products. In certain cases, these products may provide an inexpensive means of diversifying your portfolio across various product classes (e.g., equities, bonds, etc.). However, as noted below, variations of this product may be more complex and price sensitive. To learn more about ETFs, you are encouraged to visit the SEC website at: https://www.investor.gov/introduction-investing/investing-basics/investment-products/mutual-funds-and-exchange-traded-2.
Leveraged and Inverse ETFs
Leveraged and inverse, or non-traditional, ETFs are categories of ETFs that are significantly more complicated than traditional ETFs as described above and are typically designed to achieve their stated objectives on a daily basis. Due to the significant risks associated with these products, First Allied Securities prohibits any purchases of these investments.
Leveraged ETFs seek to deliver multiples (typically by two or three times – and often included in the name of the fund, like “2X” or “3X”) of the performance of the index or benchmark that they track on a daily basis. An investor purchasing this type of ETF is likely to be attempting to maximize returns in positive market conditions.
Inverse ETFs seek to deliver the opposite performance of the index or benchmark being tracked on a daily basis. They may be marketed as a way for investors to hedge exposure to downward-moving markets.
Leveraged inverse ETFs are a combination of the above two categories and seek to achieve a return that is a multiple of the inverse performance of the underlying index. An investor purchasing this type of ETF is attempting to maximize returns in a declining market and has an aggressive attitude towards risk.
Leveraged and inverse ETFs have significant risks. One of the key risks associated with such ETFs is the mathematical compounding inherent to them. Most leveraged and inverse ETFs “reset” daily because they are designed to achieve their stated objectives on a daily basis. Due to the effect of compounding, their performance over longer periods of time can differ significantly from the performance (or inverse of the performance) of their underlying index/benchmark during the same period of time. It is important to understand this concept of compounding and the risk associated with it. If you do not understand this, you should not invest in these products.
Leverage can increase volatility. The longer you hold a leveraged or inverse ETF, the greater the potential for loss. As such, these products may not be suitable for investors who plan to hold positions for longer than one trading session, particularly in volatile markets.
Like traditional ETFs, some leveraged and inverse ETFs track broad indices, some are sector-specific and others are linked to commodities or currencies, which historically have been highly volatile. To accomplish their objectives, leveraged and inverse ETFs use a range of investment strategies through the use of swaps, futures contracts and other complex instruments.
The expense ratios of leveraged and inverse ETFs are typically higher than traditional ETF products, which will increase costs and may add to any negative effects from compounding. In addition, each purchase or sale of an ETF in a brokerage account generally incurs a commission charge, which should be considered carefully when deciding to actively trade ETFs.
It’s important that you read the prospectus carefully before making an investment decision. The prospectus provides detailed information about an ETF’s investment objectives, investment strategies, risks, and costs.
The SEC produced an Investor Alert entitled “Leveraged and Inverse ETFs: Specialized Products with Extra Risks for Buy-and-Hold Investors,” and you are encouraged to review this alert in order to more fully understand the risks associated with these products. A copy of this SEC alert may also be viewed at https://www.investor.gov/introduction-investing/general-resources/news-alerts/alerts-bulletins/investor-alerts/sec-finra.
Investors should consider the investment objectives, risks and charges and expenses of the funds carefully before investing. The prospectus contains this and other information about the funds. Contact First Allied Securities or your financial professional to obtain a prospectus, which should be read carefully before investing or sending money.
Investors cannot invest directly in indexes. The performance of any index is not indicative of the performance of any investment and does not take into account the effects of inflation and the fees and expenses associated with investing.
The S&P 500 is a capitalization-weighted index of 500 stocks designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries.
A diversified portfolio does not assure a profit or protect against loss in a declining market.