Architecture INJ
What is an Exchange Traded Fund (ETF)? According to the NYSE, it is legally an open-ended investment companies or unit investment trusts registered under the Investment Company Act of 1940. The first ETF offered in 1993 was designed to track the S&P 500 Index. Many pundits declared that this new investment ushered in a new era for investors and spelled doom for traditional mutual funds. ETFs provided many benefits that investors found more favorable than traditional mutual funds. The benefits included lower costs, intraday trading, short positions, tax deferral and access to commodity, currency and emerging markets. What more could an investor want?
Beware of want you ask for, you might not like what you get. Leave it up to Wall Street to take a good thing and let the zeal for profits create unforeseen pitfalls for unwary investors and an unprepared securities industry. The latest generation of ETFs has given us investments that are leveraged and inversely correlated which do not track indexes over time and commodity investments subject to the risk of "contango." The investing public is at risk without a financial adviser who can provide advice about these new financial products.
According to a recent Cornerstone Research report, eleven class action lawsuits were filed against issuers of ETFs for the failure to track the underlying index performance. Upon closer examination of the prospectuses, the leveraged and inverse ETFs are designed to track the performance of the underlying index, on a daily basis. These ETFs were designed for short term strategies to hedge a position or profit from arbitrage for a trading session, not the long run. This fact was not lost on the class action attorneys when they argue misrepresentation and inadequate disclosure of material facts in the prospectuses. The real problem, they argued, was that the marketing and sales literature did not spell out scenarios when the ETF would not track the underlying index. Their point is investors need protection from a prospectus' "fine print" that could lead to financial ruin. What is clear is the securities industry did not step in with pronouncements from FINRA, NYSE and the SEC that warned investors about the pitfalls of these securities until the damage had already been done.
When energy and commodity prices climaxed in late 2009, investors piled into ETFs as a way to participate in the rising markets they never had been able to participate. Energy and commodity investments once considered for speculators, was now considered accessible to the average investor through an investment in ETFs. The ETFs invest in futures contracts to track the performance of the underlying commodity. The strategy assumes futures prices for the underlying commodity will be above the spot price. When the commodity markets experience "contango", futures contracts that are about to expire must be sold at unexpected lower prices to avoid physical delivery of the underlying commodity. The lower than anticipated proceeds are "rolled over" into new more expensive contracts. The result, a portion of the seed is lost, and the ETFs trail the returns of the underlying commodity over time.
What did investor losses from ETFs teach us about the financial engineering associated with this new and growing financial vehicle? It has taught us the true value of a financial adviser who can provide direction about how such a financial product works and when is it suitable based on our investment objectives and risk tolerance.