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Securities Lawyer Jonathan Kurta
By: Jonathan Kurta Author

What is an Inverse Exchange-Traded Fund?

An inverse exchange-traded fund (ETF) is a complicated investment product that is only appropriate for experienced investors who can tolerate significant risk. Exchange-traded funds are investment vehicles that pool investor funds to purchase a portfolio of securities. They make money when the shares perform well. Inverse ETFs use complex futures and options contracts to generate a return when the shares of their underlying investments lose money. Investors who do not clearly understand how an inverse ETF works often will not know whether their losses are attributable to market forces or fraud.

Understanding the Risks of Inverse Exchange-Traded Funds

Brokers should make every risk associated with inverse ETFs explicitly clear to investors. When brokers and advisors recommend inverse ETFs to their clients, they must provide adequate disclosures and take their clients’ personal risk tolerance into account. When they fail to do so, they can (and should) be held liable for investment misconduct.

  • Use of Derivatives – Inverse ETFs rely on derivatives. Derivatives are not assets like stocks or other securities, but rather contracts that expire. As a result, if an inverse ETF trading strategy is unsuccessful, investors can end up with nothing.
  • Short Selling – Short selling involves betting that the price of a stock, commodity, or another asset will go down. This is a risky strategy for retail investors on its own—even setting aside the additional risks associated with inverse ETFs.
  • Leveraged Inverse ETFs – Some inverse ETFs use leverage to maximize investors’ returns. Leverage can also magnify investors’ losses.
  • Short-Term Trading – Since short selling is generally a short-term trading strategy, inverse ETF managers must carefully time all trades. Negligent management of an inverse ETF can have drastic consequences for investors.
  • Fees and Commissions – Due to the complex and high-risk nature of inverse ETFs, these funds often charge high fees and commissions. Even if an inverse ETF strategy is successful, investors will often only see minimal (if any) returns.

How Do Inverse Exchange-Traded Funds Work? 

Also known as “short ETFs” and “bear ETFs,” inverse ETFs use derivatives to profit from shorting a security or commodity. “Shorting” allows an investor to place a bet that shares will decline in value. Short-selling contracts that have firm expiration dates which means that inverse ETFs will not have time to recover if they lose money.

What is a Derivative? 

Derivatives derive their value from an underlying contract. Futures, options, and swaps are all common types of derivatives. 

  • Futures are contracts that obligate an investor to pay a price for a certain share or commodity at a specified time. 
  • Options contracts give the investor the right to buy or sell a share for an agreed-upon price by a deadline. Unlike futures, options give the investor the right to let their option expire. 
  • Swaps trade one stream of payments for another type of payment stream. One of the payment streams in the swap is typically tied to interest on a security. 

The risks associated with derivatives are often not communicated clearly to investors, nor is the fact that inverse ETFs’ fees and expenses can entirely consume any returns.

Inverse Exchange-Traded Funds Reset 

Inverse ETFs usually reset every day, which can make them unsuitable for investors who intend to hold investments for an extended period. They can also be confusing, since their performance over one month will not directly correlate with the stock’s performance for a month. This aspect also means that a losing strategy may compound losses. 

FINRA Warns Investors About Dangers of Inverse ETFs

FINRA labels inverse ETFs as “non-traditional” exchange-traded funds and cautions that brokers must thoroughly understand how the inverse ETF plans to make a return for investors. Leveraged inverse ETFs (LIETFs) are especially complex due to their use of borrowed money. FINRA has stipulated that brokerage firms must supervise non-traditional ETFs especially closely

FINRA has published several regulatory notices to curb unsuitable recommendations of inverse exchange-traded funds: 

  • FINRA Regulatory Notice 12-03 states that firms must consider “whether the complexity would impair investor understanding of the product.” If the broker fails to adequately explain the investment, or if they have reason to believe that their investor may not understand the inverse ETF’s strategy, they may be liable for their investor’s losses. 
  • FINRA Regulatory Notice 9-31 states a broker “must understand the terms and features of the funds. including how they are designed to perform, how they achieve that objective and the impact that market volatility, the ETF’s use of leverage, and the customer’s intended holding period will have on their performance.”
  • In 2009, FINRA increased the margin maintenance requirements for investors buying shares of leveraged inverse ETFs. Margin accounts allow brokers to purchase shares with money borrowed from the brokerage firm. With higher-margin account requirements, losses from a LIETF could mean that an investor will have to deposit more money or sell securities to meet the margin maintenance requirements.  This means that LIETFs—investments that may suffer steep compounding losses—could magnify their investor’s losses even further if purchased on margin. 

FINRA Fines Kalos Over Failure to Supervise Inverse ETFs

If FINRA uncovers evidence that brokerage firms have recommended unsuitably risky leveraged exchange-traded funds, the regulator may impose a fine and order the firm to pay investors back. For instance, in 2016, FINRA alleged that Kalos Investors did not adequately supervise their broker, who recommended that investors hold their leveraged inverse ETFs for an average of 722 days. FINRA fined Kalos $30,000 and the broker $5,000. Kalos was also ordered to return $86,614 to their investors. 

Have You Lost Money Because of Inverse Exchange-Traded Funds?

If you have lost money investing in inverse exchange-traded funds, we encourage you to contact us for a free consultation. We may be able to help you recover your losses through FINRA arbitration. To find out if you have a claim for inverse ETF fraud, call 877-600-0098 or send us your information online today.

Securities Lawyer Jonathan Kurta
Written by: Jonathan Kurta

Jonathan Kurta is an accomplished securities attorney and a founding partner at Kurta Law.