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Volatile Complex Exchange Traded Products (ETFs, ETNs, etc.) May Be Unsuitable for Conservative Investors

Complex Exchange Traded Products (ETPs), such as inverse and/or leveraged exchange traded funds (ETFs) and notes (ETNs) may prove unsuitable for investors with low-risk objectives as well as clients seeking a hands-off long-term hold approach to their investments.

When SEC Commissioner Kara Stein addressed ETPs, she deemed them risky and complex investment strategies that often "operate in a gray area of mutual fund regulation." Stein explained that the exchange traded products' ability to outperform indices (or, with the case of inverse ETFs, to essentially bet against a certain benchmark index) could easily appeal to investors seeking to maximize returns, while similarly posing a threat to conservative investors simply looking to hold their positions over the long-term, since daily-resetting ETFs and ETNs can quickly spiral downward due to market volatility, daily or other short-term compounding effects, and the heightened risk especially posed by a leveraged ETF/ETN that can multiply losses just as easily as it does gains.

Take the case of the VelocityShares Daily 3x Inverse Crude ETN. This particular exchange traded note was down 46% through June 2015 whereas overall oil futures were down just 1% over the same time. Exchange traded funds and notes that reset daily are much more complex than simply taking 1% and multiplying it by three (in the case of the 3x ETN). The reason for this is volatility drag, in which daily resets allow returns to be reinvested so that, over time, proceeds are corroded and gains turned into significant losses, and that's not even including adjustments and fees that further lower a portfolio's value.

As this NASDAQ graph illustrates, volatility drag occurs when an index performs well one day and poorly the next, which causes a downward shift in both leveraged and inverse ETPs that, over time, can prove quite dramatic, as was the case with the VelocityShares Crude ETN that found itself 46% in the hole while overall oil futures had shifted just 1% over the same period. The VelocityShares Daily 3x Long Crude ETN, which is not an inverse, but is also linked to the S&P GSCI® Crude Oil Index ER, similarly was down 31% through June 2015: Two exchange traded products whose performances essentially were designed to be opposite both ended up significantly in the red.

This volatility and corrosion can cause problems in the ETP market, such as declining investor demand, poor outlooks, and significant losses that simply make such a complex product un-salvageable.

In November 2014, for instance, ALPS ETF Trust, acting on recommendation of ALPS Advisors, Inc., elected to close and liquidate three VelocityShares brand ETFs that debuted just a year earlier in 2013. Citing current market conditions and bleak prospects for growth, the ALPS Board shut down the VelocityShares Emerging Asia DR ETF, Emerging Market DR ETF, and Russia Select DR ETF. Nonetheless, the "Velocity" ETF problems paled in comparison to another big-name issuer's.

Just one month later in December 2014, ProShares, which is the largest issuer of inverse and leveraged ETFs, trading on the New York Stock Exchange, announced its own plans to shut down and liquidate 17 of its own ETFs, citing low long-term demand for the products. Specifically, ProShares Advisors, LLC recommended the shutdown of the fixed income ProShares Short 30 Year TIPS/TSY Spread, UltraPro Short 10 Year TIPS/TSY Spread, and UltraPro 10 Year TIPS/TSY Spread ETF.

ProShares also shuttered many ETFs tied to index benchmarks from Russell Investments, including the ProShares Ultra Russell MidCap Value ETF, UltraShort Russell Mid Cap Growth ETF, UltraShort Russell Mid Cap Value ETF, Ultra Russell 1000 Growth, Ultra Russell1000 Value, and ProShares' UltraShort Russell1000 Growth ETF.

Additional ProShares-Russell Investment ETFs slated for liquidation included ProShares UltraShort Russell1000 Value, ProShares Ultra Russell2000 Growth, ProShares UltraShort Russell 2000 Growth ETF, ProShares Ultra Russell 2000 Value, ProShares UltraShort Russell 2000 Value ETF, ProShares Russell Ultra3000 ETF, and the ProShares UltraShort Russell 3000 ETF.

In total, the number of announced ETF closures in 2014 approached 100 while the number of new ETFs introduced to the market in 2014 was over 200. From Exchange Traded Concept's Horizons S&P Financial Select Sector Covered Call ETF to the Source ETF Trust's EURO STOXX 50 ETF, Global X Fund's Canada Preferred and Pure Gold Miners ETF, to the Goldman Sachs Momentum ETFs (GS Momentum Builder ETFs), failure in the ETF market is a real risk.

According to ETF.com's Education Center, "a significant percentage of ETFs are currently at risk of closure" and indeed many ETFs and ETNs are not only inappropriate for long-term investing because of daily compounding effects and volatility drag, but also because of a heightened risk of closure, liquidation, and an overall shorter lifespan. As ETF.com puts it, "These products are primarily intended for professional traders...In oscillating markets, the leverage reset can significantly erode returns. A lot."

FINRA previously cautioned investors against excessive risk taking in the ETF marketplace, while also cautioning about frontier funds (e.g., the shuttered VeloCityShares ETFs) and punishing firms for overconcentration violations in ETFs and similarly complex products that are not suitable for unsophisticated or low-to-moderate risk investors.

If you have invested in a complex exchange traded product, such as an inverse and/or leveraged ETF or ETN, and have incurred undue risk due to a broker or financial adviser's unsuitable recommendations that conflict with a conservative, lower-risk investment profile, or overconcentration in a poorly-performing ETP, including the closed and abandoned Velocity or ProShares products, and these improper investments have proven harmful to your financial interests, please call The Law Offices of Jonathan W. Evans & Associates at (800) 699-1881 for investigation and consultation.

News: Here's why advisers should avoid leveraged ETFs (InvestmentNews)

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