Are Non-Traditional ETFs Suitable For Any Investor?

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Includes: TVIX
by: Adam Gana

Summary

The suitability of non-traditional ETFs.

FINRA orders JP Turner to pay restitution for sale of unsuitable ETFs.

Risks of non-traditional ETFs.

The number of non-traditional ETFs has grown significantly in popularity in recent years. By 2009, there were over 100 non-traditional ETFs in the market place with total assets of approximately $22 billion. Since 2009, the number of non-traditional ETFs has since increased to more than 250 and continues to grow.

Many investors are familiar with the properties of typical ETFs that usually track and attempt to imitate the return of a benchmark, sector, or type of security. By contrast a leveraged ETF seeks to deliver two or three times the index or benchmark return the ETF tracks by employing leverage. Non-traditional ETFs can also be "inverse" or "short", meaning that the investment returns the opposite of the performance the index or benchmark. While both traditional ETFs and non-traditional ETFs track indexes, non-traditional ETFs contain significant additional risks and are rarely appropriate for retail investors.

The additional risks of non-traditional ETFs include the risks of daily reset, use of leverage, and compounding of returns if held over a longer periods of time. Non-traditional ETFs will perform differently from the performance their underlying index or benchmark the fund tracks over time. For example, between December 2008, and April 2009, the Dow Jones U.S. Oil & Gas Index gained two percent while a leveraged ETF that tracked the index's daily return fell six percent. A related non-traditional ETF seeking to deliver twice the inverse of the index's daily return fell by 26 percent.

Another example is TVIX, according to TVIX's marketing materials, TVIX is linked to twice the daily performance of the S&P 500 Short-Term Futures Index. However, in February 2012, new issuances of TVIX were suspended, causing it to fall out of sync with the index it was tracking.

Regulators are starting to take notice. The Financial Industry Regulatory Authority (FINRA) has previously stated that leveraged ETFs carry significant risks and are inherently complex products.

Accordingly, FINRA has advised brokerage firms that these nontraditional ETFs are typically not suitable for retail investors because of the incredibly short holding period for these investments. Many brokerage firms have since prohibited their brokers from soliciting clients to invest in non-traditional ETFs.

Recently, FINRA ordered J.P. Turner & Company, L.L.C. (JP Turner) to pay $707,559 in restitution to 84 customers for sales of unsuitable non-traditional ETFs and for excessive mutual fund switches. FINRA alleged that JP Turner allowed its registered representatives to recommend non-traditional ETFs without performing reasonable diligence to investigate the risks and features associated with the products and that the firm sold the products in the same manner that it sold traditional ETFs.

All in, non-traditional ETFs can be a portion of your portfolio, but to over-concentrate in these positions before they can be fully vetted by market cycles can be a very risky proposition.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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