Following FINRA’s change to the Series 7 Content Outline in late 2011, leveraged and inverse exchange-traded funds (ETFs) became a topic that is a potential test item students may see on their exam. You can read more about ETFs in our Study Manual, but let’s visit them briefly here.

Wall Street has a long tradition of financial innovation, and with every new product created there is always a new set of risk factors to consider, reactions to evaluate, and problems to solve. Some relatively recent innovations in the ETF industry are leveraged ETFs that produce a fund leveraged 2 or 3 times to its underlying index, and inverse ETFs that move in the opposite direction of an index, and inverse, leveraged ETFs. These nontraditional ETFs make suitability determination more critical for the investment professional.

FINRA wants registered representatives and investors alike to understand that while these vehicles potentially amplify returns, they also amplify risk. Here is how this happens. While the traditional ETFs are designed to track the value of an index on a one-for-one basis, leveraged ETFs are designed to amplify those movements 2 or 3 times. Rather than gaining leverage by buying securities on margin, investors can buy leveraged ETFs in a cash account that does not permit margin purchases, and receive the benefits of leverage without obtaining approval for a margin account. In essence, investors are exposing themselves to some, but not all, of the risks of leverage through margin. Although leverage can amplify gains, it can also amplify losses. The use of leverage through a leveraged ETF may not be suitable for many investors who cannot bear the risk. Because IRAs, self-directed 401(k) plans, and other retirement accounts are designed as nonleveraged investment arrangements, the use of leveraged ETFs in these accounts is problematic.

ETFs with an inverse investment orientation are designed to rise in value when the underlying index falls. They are used by investors with contrarian investment strategies. Investors who anticipate a decline in an index can buy an inverse ETF instead of selling short a traditional one. Conversely, if the index rises in value, an inverse ETF will fall.

Inverse ETFs give investors more flexibility in their investment strategies. For example, an investor who has an account that does not permit short selling, such as an IRA or a self-directed 401(k) plan, can participate in bearish investment strategies or can hedge a long portfolio by buying inverse ETFs. Leveraged versions of inverse ETFs are also available. This raises the question as to whether these investments are suitable in retirement, education savings, or other tax-deferred accounts that prohibit short selling.

One of the items that is crucial for a registered representative to understand and be able to communicate is the effect of market movements on an investor’s portfolio. For example, suppose an investor purchases $20,000 worth of an inverse S&P 500 ETF. If the market drops 10% on day one, but rises 5% the next day, what will the value of their investment be? The math is important to understand. First, the market drop is exactly what the investor wanted, and since the ETF is inverse, it will increase in value by the amount of the decline. So, the $20,000 investment will on day one gain 10%, or $2,000. Now it has a market value of $22,000. However the next day the market goes up 5%, which means that the ETF will lose 5% or $1,100. ($22,000 x 5% (.05) = $1,100). So the ending value of the investor’s position on day two would be $20,900. Again, understanding how to calculate these numbers is very important.

According to FINRA, because leveraged ETFs are rebalanced daily, they are not suitable for holding periods of longer than one day, unless they are used as part of a sophisticated trading strategy that is monitored by a financial professional. This is because daily leveraged compounding can cause these investments to behave differently than traditional ETFs in the long term. Daily leveraged compounding of losses can result in returns that are significantly lower than expected. It may also result in losses that are much higher, particularly in volatile markets.

While FINRA does not state how many questions may appear on a given topic, we believe that you should be prepared to answer a small number of questions about leveraged and inverse exchange-traded funds (ETFs).

Thanks for spending time with us. We hope you found it worthwhile.

—Securities Training Corporation