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Investment Fraud and Broker Negligence

Inverse or Leveraged ETFs (Exchange Traded Funds)

ETFs (or Exchange Traded Funds) have become increasingly popular over the last 15 years.  ETFs are typically used to track and replicate the performance of an index, such as the S&P 500, the Russell 2000, or the Dow Jones.  ETFs are popular, because investors can invest in a basket of securities that provides diversification but with the simplicity of being a single stock.

In recent years, many companies have also created leveraged or inverse ETFs.  Leveraged ETFs try to replicate the performance of a particular index, but attempt to replicate the performance by doubling or even tripling the index.  As an example, the Proshares Ultra Russell 2000 ETF seeks to double the performance of the Russell 2000 Index.

Inverse ETFs also try to replicate the opposite (or even multiple opposites) of a particular index.  For example, Ultrashort QQQ Shares seeks a return of two times the inverse (-2x) of the daily performance of the NASDAQ-100 Index. Leveraged and inverse ETFs can be useful investment tools for investors seeking intra-day trading.

However, inverse and leveraged ETFs are often misused, by retail investors and even financial advisors.  The regulators and others have long-warned the securities industry about the dangers of inverse and leveraged ETFs.  These are designed to be day-trading vehicles, but often financial advisors recommend holding these ETFs in an investor’s accounts for weeks or even months.

FINRA has stated that “inverse and leveraged ETFs that are reset daily typically are unsuitable for retail investors who plan to hold them for longer than one trading session, particularly in volatile markets.”  See FINRA Regulatory Notice 09-31 at page 1.  This Notice reminds members who sell these products to “make every effort to familiarize themselves with each customer’s financial situation, trading experience, and ability to meet the risks involved with such products and to make every effort to make customers aware of the pertinent information regarding the products.”  Id. at 3, citing to NASD Notice To Members 05-26.

There have been articles discussing the dangers associated with use of leveraged and inverse ETFs:

…I was shocked to learn how many people have a misconception as to how these funds [Leveraged and Inverse ETFs] work.  And this sampling was not of novice day traders – these are professionals and financial advisors.  They research a product before they dispense advice or buy something.

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With virtually every leveraged and inverse fund, I can tell you that they are appropriate only for less than 1% of the investing community.  Considering that these funds have attracted billions of dollars over the past year alone, it’s pretty obvious that too many people are using these incorrectly.

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To summarize, one fund tracks the index and lost 52% last year, one aims to deliver the inverse of the index and gained 20%, and the last aims to deliver twice the inverse of the index and lost 25%…While the fund that held the stocks lost 52%, the one that aimed to deliver twice the inverse also lost a substantial 25%.  And the funds worked like they were supposed to.

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If you were prescient enough to predict the collapse of the real estate last year, you could have earned a savory 40% return by shorting iShares Dow Jones US Real Estate (IYR).  So logic would hold that owning Ultrashort Real Estate ProShares (SRS) would have produced a positive 80% return right?  Absolutely wrong.  I say absolutely because, in absolute terms, you would have lost even more money using the double-short fund which is supposed to go up when the index goes down.  The disappointing truth: the funds worked like they were supposed to.

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Leveraged and inverse ETFs are not meant to be held as long-term investments.  Let me repeat myself:  Very bad things not only can happen whenever you hold these ETFs longer than their indicated compounding period (typically one day for stock-based ETFs, sometimes monthly for commodities), you are almost mathematically guaranteed to get a return that is not double that of the index.  In fact, the longer you hold one of these funds, the probability that you will get nothing close to double the returns increases.  Not only will the magnitude of your returns bounce around, you might not even get returns that are in the same direction as the changes in the index.

See “Warning: Leveraged and Inverse ETFs Kill Portfolios” by Paul Justice, CFA, Jan. 22, 2009 (emphasis added).  See also “Leveraged ETFs Are the Worst Investment Ever” by Howard Gold, Oct. 28, 2011.

FINRA has punished brokers and firms for using leveraged and inverse ETFs improperly.  In an action against Michael Venable, FINRA barred a broker from the industry for using unsuitable leveraged and inverse ETFs with his clients.  See In re Michael Douglas Venable.   FINRA also fined Citigroup, Morgan Stanley, UBS, and Wells Fargo a combined $9.1 million for sales of inverse and leveraged ETFs, in May 2012.

Israels & Neuman PLC is a securities law firm with offices in Denver, Colorado and the Seattle area.  We represent investors in FINRA arbitration proceedings in all 50 states.  Our attorneys have represented over one thousand investors against many brokerage firms in the past, including LPL Financial, Merrill Lynch, Morgan Stanley, Smith Barney, Stifel Nicolaus & Company, UBS Financial Services, Oppenheimer, Charles Schwab, Wells Fargo Advisors, Ameriprise Financial Services, Raymond James Financial Services, ProEquities, Securities America, National Securities Corp., and many others.

DID YOUR ADVISOR RECOMMEND INVESTMENTS IN LEVERAGED OR INVERSE ETFs THAT CAUSED YOU LOSSES?

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             Aaron Israels: (720) 599-3505

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