REGULATORY/LEGISLATIVE
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Don’t Be Fooled by the ETF Label: Single-Stock, Leveraged, and Inverse ETFs Pose Significant and Underappreciated Risks
By Scott Farnin
Several high-profile developments in the financial markets have been dominating the headlines, obscuring some less-noticed trends that pose significant risks to investors. For example, cryptocurrencies continue their widely publicized fight to gain legitimacy despite the widespread damage they have inflicted on investors. And the backlash against ESG investing is intensifying despite investors’ demand for more access to ESG investments and more disclosures from funds and issuers about the risks and returns associated with the “environmental, social, and governance” factors. Meanwhile, outside the limelight, other investment products gain traction while posing risks that many investors may not appreciate. A prime example is the growth of single-stock, leveraged, and inverse ETFs, which capitalize on the generally reassuring ETF label but come with unique complexities and risks.
Since the sale of the first ETF in 1992, the industry has grown to $6.5 trillion in assets, with nearly 3,000 different ETFs available to investors. Within the past decade alone, the net share issuance of ETFs has totaled $4.1 trillion, and total net assets more than doubled between 2015 and 2020.1 It is easy to see why investors and advisors have poured money into ETFs. These funds are typically well-diversified, low-maintenance financial products that come with low fees and give investors broad investment exposure to indexes that represent entire markets, sectors, or industries.
However, not all ETFs have these features. In recent years, the markets have witnessed the rise of complex, leveraged financial products packaged in the ETF wrapper. Specifically, single-stock, leveraged, and inverse ETFs have created new risks for both investors and advisors. A common feature is the use of derivative products to multiply returns—and often losses—over a short period of time, typically a single trading day.
Fast-Track Listing and Wider Investor Access
In recent years, the SEC has streamlined the listing process for ETFs. In 2019, the SEC fundamentally altered the way traditional ETFs are listed on national securities exchanges by adopting Rule 6c-11, which provided most ETFs with fast-track authority to list. Before 2019, each individual ETF was required to obtain an exemptive order from the SEC to operate as an investment company under the Investment Company Act of 1940. The 2019 rule change led to the listing of hundreds of ETFs on stock exchanges.
Just a year later, the SEC adopted another rule to enable more complex and volatile financial products to enter the market in the guise of an ETF. It allowed certain single-stock, leveraged, and inverse ETFs that offer investment returns of up to three times the return on an index or a single stock to take advantage of the same ETF fast-track authority for listing on an exchange. As a result, those novel ETFs have become more widely available.
Variety of Risks
While these complex financial products are listed on exchanges with an ETF wrapper, they present unique risks to investors and advisors. Instead of holding shares of individual companies that make up a certain index, single-stock, leveraged, and inverse (for those seeking a short position) ETFs hold complex derivative instruments—such as swaps and options—in the search for leveraged or amplified returns. This not only greatly increases the volatility of the ETF but also introduces counterparty risk that hinges on the ability of the other side of the swap contract to fulfill its obligations in a timely manner. Additionally, these ETF products are generally associated with much higher fees and, in the case of single-stock ETFs, lack the diversification that investors associate with a traditional ETF. Finally, and most importantly, these ETFs reset daily, which can materially alter investor returns for the worse if they are held beyond a short period.
Regulatory Cautions
An “Investor Alert,” published in February 2023 and updated in late August by the SEC’s Office of Investor Education and Advocacy, provides real-world examples of how the daily reset of these new ETF products can wildly diverge from the returns of the underlying index when the ETF is held for an extended period. It highlights the returns of a particular index over the course of a four-month period contrasted with the returns of leveraged and inverse ETFs seeking double and triple the returns of the index, summarized as follows:
Real-Life Examples of Leveraged/Inverse ETF Returns2
Performance over four-month period
| Example #1 | |
| Index | +2% |
| 2x ETF | -6% |
| 2x Inverse ETF | -25% |
| Example #2 | |
| Index | +8% |
| 3x ETF | -53% |
| 3x Inverse ETF | -90% |
This divergence between the underlying index and the actual returns of the leveraged and inverse ETFs highlights the clear risks to investors who hold them over time. The last two chairs of the SEC, a number of current and former SEC commissioners, the SEC investor advocate, and heads of the divisions of the SEC have all commented in recent years on the unique risks posed by single-stock, leveraged, and inverse ETFs.
In particular, the daily reset mechanism found in these products makes them suitable only for those willing and able to trade and monitor them daily. Unlike traditional, well-diversified, low-maintenance, low-fee ETFs that seek to replicate the performance of an underlying index by holding securities that make up the index, single-stock, leveraged, and inverse ETFs are not buy-and-hold investments. In fact, the SEC stated in the adopting release for Regulation Best Interest in 2019 that “broker-dealers recommending such products should understand that inverse and leveraged exchange-traded products that reset daily may not be suitable for, and as a consequence also not in the best interest of, retail customers who plan to hold them longer than one trading session.”3
SEC Enforcement Actions
The SEC has brought enforcement actions against investment advisor firms and advisors for breaching their fiduciary duty to clients in connection with these ETF products. For example, in 2020, the SEC brought an action against a large advisory firm for failing to supervise advisors who recommended single-stock, leveraged, and inverse ETF investments to retail investors, and it ordered the firm to pay $35 million in restitution to harmed investors.4 In 2023, the SEC brought an enforcement action against an advisory firm and an investment advisor for violating their fiduciary duty to clients by investing significant amounts of investor assets in leveraged ETFs.5 The SEC found that the advisors maintained those positions for extended periods despite the prospectuses of those funds clearly stating that positions should be held for no more than a single trading day. The firm and the advisors agreed to a cease-and-desist order, censures, and the payment of nearly $1 million in disgorgement, interest, and penalties.
Be Wary of Complex ETFs!
Single-stock, leveraged, and inverse ETFs pose clear and heightened risks to investors. Their features, including the daily reset mechanism, make clear that these products are meant to be closely monitored and held for a single trading day. These products are unlikely to be suitable for or in the best interest of an average retail investor, especially if held for any extended period. Investment advisors who recommend such strategies to their clients may well have to explain why their returns do not match the stated goals of the ETF—and they may also have to explain to the SEC why they recommended those investments at all.
1. Investment Company Institute, 2023 Investment Company Fact Book: A Review of Trends and Activities in the Investment Company Industry 54.
2. Data derived from U.S. Securities and Exchange Commission, SEC Office of Investor Education and Advocacy, Updated Investor Bulleting: Leveraged and Inverse ETFs (Feb. 23, 2023).
3. Regulation Best Interest: The Broker-Dealer Standard of Conduct (File No. S7–07–18, RIN 3235–AM35) 84 Fed. Reg. 33,318, 33,376 (July 12, 2019).
4. U.S. Securities and Exchange Commission, SEC Charges Wells Fargo In Connection With Investment Recommendation Practices (Feb. 27, 2020).
5. U.S. Securities and Exchange Commission, SEC Charges Advisory Firm and Part-Owner for Breach of Fiduciary Duty in Connection with Use of Leveraged ETFs (May 4, 2023).
Scott Farnin is legal counsel at Better Markets, a nonprofit, nonpartisan, and independent organization founded in the wake of the 2008 financial crisis to promote the public interest in the financial markets, support the financial reform of Wall Street, and make our financial system work better for all Americans..
image credit: istock.com/D-Keine
