The Dark Side of the ETF Craze

Exchange-traded funds have brought simplicity and convenienceto millions of investors. But in the hands of big financial institutions, some ETFs have left a path of financial destruction in their wake -- and even the industry's own watchdog is taking notice.

Yesterday, the Financial Industry Regulatory Authority, also known as FINRA, laid down the law against four companies that used leveraged and inverse ETFs in ways that the regulatory body found unsuitable for clients. Later in this article, you'll find details about which companies were involved and how much FINRA's sanctions will cost them. But first, let's get everyone up to speed on the benefits and pitfalls of these high-risk ETFs.

At first glance, the purpose of leveraged and inverse ETFs seems easy to understand. Inverse ETFs should give you the same results as selling an investment short, while leveraged ETFs should multiply your returns two- or threefold. And that's exactly what most such ETFs do -- when you focus on short periods of time.

The challenge, though, is that most leveraged ETFs are designed to track daily returns. Over longer periods, though, what happens to the ETF depends on which direction the market goes. In general, if the market moves firmly in one direction without many countermoves along the way, then a leveraged ETF can provide higher long-term returns than you'd expect. But if the market bounces around, then leveraged ETFs often fall short of doubling or tripling their benchmarks.

The silver-tracking ProShares Ultra Silver (NYS: AGQ) and ProShares UltraShort Silver (NYS: ZSL) give you a good example of just how badly long-term investing in leveraged ETFs can go. Over the past year, silver prices have lost about 35% of their value, so as you'd expect, the bullish silver ETF is down sharply -- 72% since May 2011. But the bearish silver ETF is also down, with a 17% drop over the same time period.

With those long-term results, it's clear that leveraged ETFs are only suitable for short-term traders. But FINRA discovered some alarming things in its examination of Wall Street firms:

  • Citigroup (NYS: C) allowed investors in their late 50s who identified themselves as conservative to hold "nontraditional" ETFs for months, leading to significant losses.

  • At Morgan Stanley (NYS: MS) , brokers made solicited nontraditional-ETF trades for an 89-year-old customer seeking income from her portfolio. The trade amounted to almost 60% of the value of the customer's account and caused losses of more than $10,000 -- a devastating result for the customer, whose net worth was less than $200,000.

  • Wells Fargo's (NYS: WFC) FINRA examination revealed a 92-year-old conservative customer who owned a nontraditional ETF for four and a half months, as well as a 65-year-old whose losses amount to more than half of the customer's reported net worth.

faced similar sanctions, and together, the four firms will pay $7.35 million in fines and about $1.8 million to replace client losses resulting from their failure to oversee their leveraged and inverse ETF holdings and practices.

These experiences provide two valuable lessons for investors. First, leveraged and inverse ETFs are financial dynamite, and holding them in your portfolio for any length of time can create huge losses.

But more importantly, the brokers who work at these and other financial-service providers clearly don't understand these products. Yet in some cases, they're actively recommending leveraged ETFs to customers who have already said that they're not interested in taking on the level of risk involved.

Given their huge popularity, ETFs have created high demand among investors. It's easy to see how disreputable professionals could take advantage of inexperienced clients and their lack of knowledge -- and so it's more important than ever to keep on your guard and understand what you're investing in before you buy it.

In some ways, individual stocks give you more protection than ETFs, because with stocks you at least know what you're buying. For conservative investors interested in dividends, our special free report on nine promising dividend stocks may be of interest. Take a look -- it's on us. Just click here to get started.

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At the time thisarticle was published Fool contributor Dan Caplinger always looks for the catch. He doesn't own shares of the companies mentioned in this article. The Motley Fool owns shares of Citigroup and Wells Fargo and has created a covered strangle position in Wells Fargo. Motley Fool newsletter services have recommended buying shares of Wells Fargo. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Fool's disclosure policy won't lead you to the dark side.

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