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Exchange Traded Funds

“ETFs” are not so new investment products that have recently become one of the most popular investment vehicles in the United States. Similar to mutual funds, ETFs are comprised of a “basket” of underlying assets. Those assets can be commodities such as gold or silver, bonds, common stock, etc. Typically, the assets will consist of underlying investments in a particular industry or sector (there are even ETFs in which the underlying assets are other ETFs).

While ETFs act as a mutual fund and track the performance of the underlying assets, they are different from mutual funds in many respects. The most significant difference is that the price of ETFs fluctuates daily; ETFs trade on exchanges similar to a common stock. Expenses involved with ETFs are typically lower than those of mutual funds. Since ETFs are made up of underlying assets, they necessarily provide greater diversification than buying an individual stock, bond or commodity.

However, what concerns regulators and others is the development of related investment products: inverse and leveraged ETFs.

An inverse ETF is structured to deliver returns that are the inverse of its underlying “basket” or index. It does so by using various derivative products. Inverse ETFs are particularly aggressive and speculative products that entail various risks, including compounding risk, derivative securities risk and short sale risk. Furthermore, inverse ETFs are meant to be held for one day; this necessarily involves frequent turnover.

A leveraged ETF also has a basket of underlying assets. A leveraged ETF borrows against the underlying basket of assets to increase the size of the basket and thereby increase (possibly) the rate of return. Of course, the converse is true; if the underlying assets underperform, the underperformance of the leveraged ETF increases accordingly.

Lastly, there are also inverse leveraged ETFs.

Both inverse and leveraged ETFs are meant to be trading vehicles and not to be held for the long term. With the use of derivative products to enhance their performance, they are very complex and are not suitable for many investors. Indeed, many brokerage firms, recognizing the complexity of these products, prohibit their brokers from soliciting their customers to purchase leveraged or inverse ETFs.

As can be seen from the above, inverse and leveraged ETFs should only be purchased by sophisticated investors who are seeking to actively participate in the market.

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