Non-traditional ETFs: Stop, look and listen before you invest

Patricia Foster//November 9, 2023//

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The first U.S.-based exchange traded fund made its debut thirty years ago when State Street Global Advisors launched the SPDR S&P 500 ETF Trust. Now, three decades later, a dazzling array of exchange-traded investment products are available to investors. According to the Investment Company Institute (ICI), at the end of 2022, there were 2,989 ETFs having an aggregate market value of nearly $6.5 trillion. In this column we consider the emergence of the ETF as a popular investment product. We will look at the attributes of both traditional and non-traditional ETFs and we will make the case for a cautionary approach when it comes to considering an investment in a non-traditional ETF.

What is an ETF?
ETFs are a subset of a larger category of exchange-traded products. An ETF is a pooled investment vehicle that offers investors access to a professionally managed investment portfolio of securities at a reasonable cost. Each ETF share represents an investor’s proportionate ownership of that portfolio and the income generated by the portfolio. Like mutual funds, ETFs are registered under the Investment Company Act of 1940. While ETFs bear some resemblance to mutual funds, they are structured differently. Unlike mutual funds, ETFs do not sell shares directly to, or redeem shares directly from, investors. Unlike mutual funds, ETFs are traded throughout the day on national stock exchanges at market prices. As a result, an ETF’s market price fluctuates throughout the day and may be more or less than the net asset value (NAV) per share. Shares that sell at a price higher than the NAV are sold at a premium whereas shares sold at a price lower than the NAV are sold at a discount.

Traditional ETFs
Many ETFs seek to replicate the performance of a broad-based market index. For example, the SPDR S&P 500 ETF Trust, launched thirty years ago, seeks investment results that, before expenses, generally correspond to the price and yield performance of the common stocks that comprise the S&P 500 Index. It is the largest ETF in the world with over $370 billion in assets under management. In addition to the index-based ETFs, which comprise the largest share of ETF assets, investors may now purchase actively managed ETFs which do not seek to replicate the performance of an index. The actively managed ETF allocates portfolio assets in accordance with a stated investment objective.

Non-traditional ETFs
ETFs generally characterized as “non-traditional” include leveraged ETFs and inverse ETFs which seek investment returns on some basis other than that of a broad-based market index. These investment products are not well understood by most investors and many financial advisors. Rather than seeking to replicate the performance of a specific index, non-traditional ETFs utilize the performance of a specified index to seek investment returns that vary from that of the index. Unlike the traditional index-based ETF which seeks investment returns on a “one-to-one long only” relationship to an underlying index, the leveraged ETF seeks a return that corresponds to a multiple of the daily return of the underlying index. For example, a 2X leveraged ETF seeks to double the daily performance of the underlying index. An inverse ETF seeks to deliver the opposite of the daily performance of the underlying index. Inverse ETFs are sometimes referred to as “short” funds because they are marketed as a way for investors to either profit from, or at least hedge their exposure to, downward moving markets. Non-traditional ETFs use derivatives to achieve these returns.

The characteristic that distinguishes non-traditional ETFs from traditional, index-based ETFs is the “reset” feature. Because leveraged and inverse ETFs are designed to achieve their stated performance objectives on a daily basis, they are structured to “reset” in relationship to the underlying index, typically on a daily basis. Unless an investor’s portfolio is managed to closely monitor the results of the daily reset, a portfolio that includes a leveraged or inverse ETF that resets on a daily basis, may not perform in accordance with its stated investment objective.

Regulatory concerns about inverse and leveraged ETFs
While the “reset” feature is the defining characteristic of these non-traditional ETFs, it has also been a focus area for regulators, including the Financial Industry Regulatory Authority (FINRA) and the U.S. Securities and Exchange Commission (SEC). Performance results over multiple reset periods can be unpredictable. In its “Updated Investor Bulletin: Leveraged and Inverse ETFs” published on August 29, 2023, the SEC’s Office of Investor Education and Advocacy stated that it believed that investors may be confused about the performance objectives of leveraged and inverse ETFs. The Bulletin states:

Leveraged and inverse ETFs are designed to achieve their stated performance objectives on a daily basis. Some investors might invest in these ETFs with the expectation that the ETFs may meet their stated daily performance objectives over the long term as well. Investors should be aware that performance of these ETFs over a period longer than one day can differ significantly from their stated daily performance objectives and may potentially expose investors to significant and sudden losses (emphasis added).

The Bulletin, which is available on the SEC’s website, provides examples of how the compounding effects of the daily reset feature can lead to unexpected results for investors, especially for “buy-and-hold” investors. These examples also illustrate that the math matters.

Additional thoughts
Non-traditional ETFs are complex investment products. The Bulletin encourages investors who might be considering an investment in either a leveraged ETF or an inverse ETF to consult with an investment professional who not only understands your investment goals and tolerance for risk, but also understands these complex products. It is also very important to read the prospectus which provides detailed information about the ETF’s investment objectives, investment strategies, risks and costs. Caveat Emptor!

Patricia Foster is a securities law attorney whose experience includes representation of clients in both registered and exempt securities offerings, as well as in various sectors of the financial services industry, including broker-dealers, investment advisers and investment companies. This column is a collaborative work by Patricia Foster and David Peartree. David Peartree is an adviser with Brighton Securities Capital Management, Inc., a registered investment adviser offering fee-only investment and financial planning advice. The information in this column is provided for educational purposes and does not constitute legal or investment advice.