Essentially, leveraged inverse funds seek to deliver the opposite of the performance of the index or benchmark that they track. These ultra short funds employ a strategy akin to short-selling a stock (or basket of stocks), in conjunction with employing leverage, and in so doing these funds seek to achieve a magnified return on investment that is a multiple of the inverse performance of the underlying index.
For example, the ProShares UltraPro Dow30 ETF (NYSE: SDOW) is structured to provide a return that is -3% of the return of the underlying index, the Dow Jones Industrial Average. Thus, if the Dow Jones were to lose 1% in value, SDOW is structured to gain 3%. While in theory this might seem a straightforward proposition, the fact is that such ultra short funds are exceptionally complicated and risky financial products.
The greatest risk associated with leveraged inverse ETFs involves purchasing these products in a buy-and-hold scenario. Put another way, these products are not designed to be held for more than single trading day, and it is for this reason that such funds should only likely be purchased by professional investors for hedging and day trading purposes. To understand why investing in ultra short ETFs or mutual funds for more than single trading day (buy-and-hold) is likely unsuitable, it is helpful to review the summary prospectus for one inverse ETF, ProShares Short S&P 500 (NYSE: SH), and its disclosure concerning “compounding risk”:
The Fund has a single day investment objective, and the Fund’s performance for periods greater than a single day will be the result of each day’s returns compounded over the period, which is likely to be either better or worse than the Index performance times the stated multiple in the Fund’s investment objective, before accounting for fees and fund expenses. Compounding affects all investments, but has a more significant impact on an inverse fund. Particularly during periods of higher Index volatility, compounding will cause results for periods longer than a single day to vary from the inverse (-1x) of the daily return of the Index. This effect becomes more pronounced as volatility increases.
Aside from compounding risk, the other obvious risk associated with leveraged inverse funds has to do with their leverage, or their use of derivatives such as futures contracts to magnify their exposure to the underlying index or benchmark. For the uninformed and unsophisticated retail investor, it is likely an unsuitable investment strategy to purchase a financial product with 3X leverage. This is because in the event that the investment theme does not pan out, any losses will be magnified by the corresponding degree of leverage.
As of early October 2017, the following leveraged inverse ETFs are among the worst performing ETFs this year:
When a financial advisor recommends an investment to a customer, the broker and his or her firm has a duty to first conduct due diligence on the investment. In addition, pursuant to the rules and regulations set forth by the Financial Industry Regulatory Authority (“FINRA”), the financial advisor, and by extension his or her firm, must seek to ensure that they conduct a suitability analysis in order to determine if the investment being recommended is suitable for the investor in light of certain factors, including the customer’s age, risk tolerance and stated objectives, net worth and income, and degree of sophistication with investing.
If you have invested in any leveraged inverse ETFs or mutual funds, including the above referenced ultra short funds, you may be able to recover losses sustained in FINRA arbitration. Investors may contact a securities arbitration lawyer at Law Office of Christopher J. Gray, P.C. at (866) 966-9598 or newcases@investorlawyers.net for a no-cost, confidential consultation.