We are cheerleaders for ETFs. We believe they are a superior fund structure for most portfolios and most investors. ETFs have grown rapidly and their portfolios include many categories of assets, but some funds available today are very different from the original S&P 500 SPDRs. Consequently, some of the newer funds do not meet all investor expectations. In many instances the newer funds have been greeted warmly by most investors. In other cases all investors are not sure that the funds are a good idea. Some funds trade farther from NAV than many investors consider reasonable. Most leveraged ETFs do not behave like a leveraged position in a margin account. The names of some funds do not match the fund’s holdings as nearly as they might. These and other developments can lead to investor disappointment. The purpose of this page is to answer questions related to such disappointments – and the costly litigation that sometimes stems from disappointments.
1. I have read that a number of leveraged ETFs have been sued by investors. What is going on?
Leveraged long and leveraged inverse funds have been around for a number of years. Long before the ETF versions of these funds were cleared by the SEC, leveraged long and inverse mutual funds were popular with a small group of aggressive traders. The leverage on the mutual funds was usually limited to two times and, historically, day-to-day market volatility has usually not been very dramatic. In late 2008, some leveraged ETFs offered three times leverage and there were a number of very substantial day-by-day up and down moves.
The statements of additional information (SAIs) for leveraged funds have long carried tables showing the effect of high market volatility on the pattern of leveraged fund returns. These tables are now included in the summary prospectuses of leveraged funds and the tables have been widely reproduced and discussed by market commentators. Chapter 10 of the Second Edition of The Exchange-Traded Funds Manual discusses how and why high day-by-day volatility reduces the return from a leveraged ETF, even if the market is moving in the direction the investor expects leverage to pay off. At times in late 2008 and early 2009 the daily moves in alternating directions were so large that both leveraged long and leveraged short funds on the same index had negative returns. Obviously, volatility so high that both long and short funds have losses is an extreme case, but investors who buy shares in a fund that gives them three times the daily return both up and down, should understand that a sequence of alternating large gains and large losses will erode their capital – even if the market moves in the direction they anticipated.
To the best of my knowledge, the operators of these funds have consistently met contemporary SEC standards for disclosure of the funds’ risk characteristics from the time the funds were first launched. The SEC tightened the risk disclosure standards after investors began to have performance experiences that they had not anticipated. In retrospect, more in-your-face disclosure and warning labels might have been desirable sooner, but the sad fact is that most investors do not read fund disclosure documents. The investor “surprise” at leverage fund results in the 2008 market environment made it clear that a lot of people who bought these funds did not understand what they were buying.
I often stress the importance of reading disclosure documents. The regulators and most of us who make our living in the securities business usually urge careful reading of prospectuses. Personally, I also read statements of additional information if the product is new or complex.
2. I heard recently that several small ETFs that were not trading actively had closed. This sounds like a terrible event for an investor when an ETF closes?
This is one topic where I have personal experience. I was involved in the first ETF closing back in 2002. In that case and, to the best of my knowledge in other ETF closings in the U.S., the investors in closed funds received the net asset value of their shares at the time of closing. I do not believe there have been any material costs charged to shareholders or delays in distributing cash. I am not aware of significant losses associated with liquidation of the fund portfolios.
Some investors outside the U.S. have not always been as fortunate when their funds have closed. Investors in one group of non-U.S. ETFs that closed were charged for the funds’ unamortized start-up costs. In this case, the investors did not receive the net asset value they had the right to anticipate.
Obviously, it is better to invest in a fund that is a success than one that is a failure, but being a shareholder in a fund that closes is not usually a financial disaster for U.S. investors.
Disclosure:Gary Gastineau does a limited amount of ETF litigation and expert witness work.
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