Can Be Plain or Fancy
virtually nowhere, exchange-traded products
have grown to over $3 trillion in assets.
A small portion of these products are
exchange- traded notes (ETNs), but most
are exchange-traded funds (ETFs): typically,
pools of securities that trade like stocks.
large amount of ETF assets, in turn, are
in funds that track major stock market
indexes such as the S&P 500 and the
NASDAQ 100, as well as small-company indexes,
foreign stock indexes, and so on. These
ETFs tend to be low cost and tax efficient,
so many supporters of a fiduciary standard
for advisors (see the article, "What
the New Federal Fiduciary Rule Means to
Investors" in this issue) believe
that the new rules favor ETFs as being
in the best interests of many investors.
Indeed, one Morningstar analyst has asserted
that an estimated $1 trillion of investment
assets will shift into ETFs.
However, not every ETF is a low-priced
proxy for a major index. As ETFs have
proliferated, they've spread into what
seems to be every nook and cranny an investor
might want to explore. For example, there
are ETFs that track an energy stock index,
ETFs that track exploration and production
companies, even ETFs that track crude
oil futures. There are ETFs that track
specific foreign currencies, high-yield
foreign bonds, certain hedge fund strategies,
and so on.
recent years, leveraged and inverse ETFs
have gained popularity. Leveraged ETFs
may be known as 2x or 3x ETFs, meaning
that they move two or three times as much
as the underlying index or commodity price
or some other baseline.
ETFs move in the opposite direction of
2: Carl Davis buys an inverse ETF
that tracks the NASDAQ 100. If that index
goes up 5%, Carl's ETF goes down by 5%.
If the NASDAQ 100 drops by 5%, Carl's
ETF enjoys a 5% price gain.
ETFs are both leveraged and inverse. Thus,
they move in the opposite direction of
the benchmark and those moves are magnified
two or three times.
3: Eve Foster buys a 2X inverse ETF
on the Russell 2000 index of small company
stocks. If that index goes up 5%, Eve's
ETF goes down by 10%. If the Russell 2000
drops by 5%, Eve's ETF enjoys a 10% price
The preceding examples are simplified.
In the real world, leveraged and inverse
ETFs are more complex because these ETFs
typically are reset daily. Over time,
the results produced may vary widely from
4: Suppose Eve Foster invests $10,000
in a 2Xlnverse ETF on the Russell 2000,
as in example 3, and the index gains 5%
on Monday, from 1100 to 1155. Eve's 2X
inverse ETF falls by 10%, from $10,000
suppose the index falls back to 1100 on
Tuesday. That's a 4.76% drop, from 1155
to 1100, so Eve's 2X inverse ETF gains
twice as much- 9.52%-from $9,000 to $9,857.
In the two-day period, the underlying
index is back to where it started, but
Eve's 2X inverse ETF has lost value.
true that stock market indexes seldom
move 5% on a single day. However, moves
of 1% or more occur with some frequency,
and the principle is the same. Especially
if such an ETF is held for an extended
time period, the daily resets can cause
the result from holding a leveraged or
inverse ETF to diverge widely from the
performance of the underlying benchmark.
Leveraged and inverse ETFs pose risks,
but there are reasons that they have grown
in popularity. Used astutely, these ETFs
might enable you to increase investment
returns or hedge certain portfolio risks.
If you work with a skilled advisor who
is familiar with leveraged and inverse
ETFs, you may be able to gain more control
over your investments while boosting upside
November 2016 AICPA Client Bulletin