Exchange-Traded Funds: Risks and Firms that Have Lost Investors’ Money
Exchange-traded funds (ETFs) allow investors to pool their funds to make money from a bundle of underlying stocks, bonds, commodities, or currencies. While ETFs share some characteristics with mutual funds, there are some key differences, which add to the risks for retail investors.
Like individual stocks, shares of ETFs fluctuate in value throughout the day. The value of an exchange-traded fund is based on the ETF’s performance, and the better an ETF performs, the more investors stand to earn. However, if an ETF underperforms (or fails entirely), investors may find themselves wondering why they trusted their broker’s strategy. When an ETF uses leverage, the consequences of underperformance or failure can be even more drastic for investors. Recommending overly risky ETFs could qualify as a type of broker misconduct called unsuitable recommendations.
Types of Exchange-Traded Funds
Broadly speaking, ETFs can be divided into two categories: index-based ETFs and actively managed ETFs. Most ETFs are index-based. This means that they track a particular index, such as the S&P 500, and they invest primarily in securities listed with that index. With an actively managed ETF, the fund’s investment strategy is not tied to a particular index but instead is determined by a manager who makes investment decisions on a day-to-day basis.
Exchange-traded funds may also be classified as the following:
- Bond ETFs – These ETFs may invest in corporate bonds, government bonds, or municipal bonds
- Commodity ETFs invest in commodities such as crude oil or gold.
- Currency ETFs invest in foreign currencies by trading in currency pairs, and investors profit from fluctuations in the value of the “base” and “quote” currencies in each pair.
- Stock ETFs may invest in a portfolio of stocks within a particular industry or market sector. They may also be referred to as industry ETFs or sector ETFs.
Traditional vs. Non-Traditional ETFs
Exchange-traded funds have a reputation for offering diversity without adding much risk, but the same does not hold for non-traditional ETFs, which are extremely risky. Non-traditional ETFs (NT-ETFs) can be leveraged, inverse, or both. They are not suitable for most investors.
- Inverse ETFs use derivatives to “short” stocks, allowing investors to profit when a stock’s value declines.
- Leveraged ETFs attempt to increase returns by investing with borrowed money.
Risks of Non-Traditional ETFs
Non-traditional ETFs require some specialized knowledge and careful management. ETFs reset every day, so losses can compound over time. If they lose money, brokers must intervene to stop them from hemorrhaging money. FINRA states in their Non-Traditional ETF FAQ: “While it is not FINRA’s position that all leveraged and inverse ETFs are unsuitable for all retail customers, firms that recommend them must carefully consider their suitability for each customer. Of particular concern, in light of their reset feature, is whether one is recommended as an intermediate or long-term investment rather than as part of a closely monitored trading or hedging strategy.” In other words, brokers who recommend non-traditional ETFs should be prepared to closely manage their investor’s funds.
- One broker agreed to pay a $5,000 fine following allegations that his mismanagement of non-traditional ETFs resulted in $80,000 in losses. The broker allegedly did not realize the losses associated with NT-ETFs compound based on how the valuations reset each day. This is a basic principle of non-traditional ETFs — investors should never have to suffer losses stemming from this type of broker negligence.
- FINRA highlighted the effects of compounding losses in a regulatory notice: An ETF seeking to deliver three times the inverse of the Russell 1000 Financial Services Index declined by 90% when the index gained just 8%.
Securities Lawyer Explains Risks Associated with Exchange-Traded Funds
Investing in an exchange-traded fund comes with two types of risks: 1. The risks that underlying stocks or investment strategies will not perform as hoped, and 2. The risk that a broker might mislead you about the supposed risks and benefits of a particular ETF.
- Recently, a popular ETF called ARK Innovation suffered significant losses following concerns over the effect of the omicron variant on the economy. The ETF invests in “disruptive” companies, like Tesla and Robinhood, which depend on a bustling economy for continued growth. Even though it wasn’t a non-traditional ETF, ARK still posed a risk because of its underlying investments. Brokers should be aware of these risks and communicate them clearly to investors.
- In addition to losing their principal if an ETF underperforms, investors can also lose their money to various forms of fraud. For example, one of the major differences between mutual funds and ETFs is that ETFs do not sell shares directly to retail investors. Instead, investors must work with “Authorized Participants,” or brokers who have a contract to sell shares on an ETF’s behalf. Brokers have a direct financial interest in selling as many shares as possible, meaning they won’t always have investors’ best interests in mind.
Firms Fined by FINRA Over Recommendations of Non-Traditional ETFs
Brokerage firms must include written supervisory procedures that prevent brokers from recommending ETFs that do not meet FINRA’s suitability standard.
These are just a few examples of firms that FINRA fined following allegations that they failed to protect their investors from unsuitable non-traditional ETFs:
Aegis
FINRA fined Aegis $1,050,000 and ordered the firm to pay $1,692,256.44 to their investors following allegations that the firm had not established written supervisory procedures designed to prevent brokers from recommending unsuitable non-traditional ETFs. Within 30 days of the Acceptance, Waiver, and Consent agreement, Aegis was required to submit a certification that the firm established supervisory procedures to protect its customers from unsuitable non-traditional ETFs.
SunTrust
From 2015 to 2018, SunTrust representatives allegedly solicited investors to purchase 60 non-traded ETFs. FINRA alleges that half of these non-traditional ETFs resulted in losses for investors.
SunTrust had supervisory procedures regarding non-traditional ETFs in place, but FINRA alleged they did not provide adequate training for their brokers. For instance, training did not discuss how holding these stocks for an extended period would affect their value. The firms also did not have any supervision in place to catch instances where investors held their non-traditional ETFs for too long. After FINRA began its investigation, SunTrust returned $445,836.27 to investors. FINRA ordered them to repay an additional $138,629.86 and imposed a fine of $50,000.
Oppenheimer
Oppenheimer has also faced FINRA allegations regarding an inadequate written supervisory system. According to the regulator, three senior investors with relatively low incomes and conservative financial goals collectively lost $65,754 after buying shares of non-traditional ETFs. FINRA has stated that the firm should have detected that these non-traditional ETFs were not suitable for elderly investors.
Find Out if You Have a Claim for ETF Fraud
Excessive fees, inadequate disclosures, negligent management, and various other issues can also leave ETF investors with fraudulent losses. When investors suffer fraudulent losses, they can pursue claims for financial recovery in court or through FINRA arbitration.
Do you have a claim for ETF fraud? Schedule a free, no-obligation consultation to find out. To discuss your legal options with an ETF securities lawyer, call 877-600-0098 or tell us how we can reach you online now.