What Are ETFs, Exchange-Traded Funds, and How Do They Work? Are ETFs Safe or Risky? Not All ETFs Are Created Equal

In recent years, exchange-traded products, “ETFs,” have become increasingly more popular on Wall Street and in the investor community. Institutional investors and retail investors alike have invested in exchange-traded products. Astoundingly, exchange-traded funds are a trillion-dollar market that continues to grow in value with passing time. While some ETFs are like mutual funds, others are a speculative gamble. There are many ETFs that investors should be wary of before deciding to invest. Not all ETFs are created equal.

What are Exchange-Traded Funds and How Do They Work?

Exchange-traded funds are securities that track an index, basket of stocks, bonds or a commodity. For an investor to own an ETF is the equivalent of indirectly holding a share of the total basket of underlying assets. In return, the investor receives a proportional amount of the fund’s profits and residuals. Investors can also use exchange-traded funds as a tracking mechanism for exposure to a specific index or collection of securities.

How are Exchange-Traded Funds Like Stocks and Bonds?

Exchange-traded funds have attributes in common with mutual funds and stocks; often being described as their hybrid financial instrument. Similar to mutual funds, exchange-traded funds are also a collective investment of securities through a pooled investment vehicle. Ownership of mutual funds and ETFs encompass part of the assembled portfolio. The main distinction from mutual funds is that exchange-traded funds are marketable securities that can be traded on the stock exchange at any time of the day. Additionally, exchange-traded funds can be passively managed and do not require an individual to manage actively manage the assets as needed in mutual funds.

What are the Benefits of Exchange-Traded Funds?

The ease at which exchange-traded funds can be traded on the market at any point of the day fosters excellent liquidity. For that reason, exchange-traded funds can make for an effective short-term investment. Markedly, exchange-traded funds can work as a means for investors to diversify their investment portfolio to decrease risk. Other purported benefits of exchange-traded funds include their simplicity, liquidity, flexibility, and affordability. Notably, exchange-traded funds can benefit from economies of scale from their lower transaction costs and competitive management fees. On top of this, exchange-traded funds do not have a minimum purchase requirement.

Can Exchange-Traded Funds Be Risky Investments?

Non-traditional exchange-traded funds are far more complex and carry a higher risk than simple, traditional exchange-traded funds. Non-traditional exchange-traded funds use gearing or leverage to amplify the value of the returns or losses from the underlying assets. These risky financial instruments could only be suitable for speculative investors who could afford to lose. Leveraged ETFs are very risky financial products that rely on margin to amplify any produced gains. Most popular in bear markets, inverse exchange-traded-funds use derivatives to perform as the inverse of an underlying index for profits as a result of any declines. Many of these funds should not be held more than one trading day and are unsuitable for average investors.

In general, exchange-traded funds are too risky and complex for investment professionals to solicit to an unsophisticated investor. Investors should read risk disclosures in prospectuses, as well as, ask investment professionals selling the products lots of questions. Our investment fraud attorneys have represented numerous unsophisticated investors who lost money from unsuitable exchange-traded products solicited by brokers. Nevertheless, investors do sometimes get caught up purchasing investments based on unsuitable recommendations from their broker. Unscrupulous brokers often will fraudulently promise high gains without highlighting the many risks from investing in certain ETFs.

How can Investors in Exchange-Traded Funds Stay Safe?  

FINRA has pursued claims against brokers and brokerage firms for their errors in the practice of recommending suitable investments. Pursuant to FINRA rule 2111, brokers can only recommend ETFs that are reasonably determined to be suitable according to their client’s age, investment experience, tax status, net worth, risk tolerance, and other factors. Broker recommended investment strategies should align with investor objectives. Additionally, brokerage firms have an obligation to enforce an adequate supervisory system with reasonable procedures in place to monitor broker’s sales of exchange-traded products. Additionally, brokers are obligated to disclose pertinent information regarding any investment fully. Otherwise, the broker, as well as the “supervising” brokerage firm are liable for fraud from misrepresentations and omissions.

Proceed with caution and thoroughly evaluate the risks before choosing to invest in exchange-traded funds. In many cases, the best investment strategy for exchange-traded funds should encompass diversification to mitigate risks. Watch out for brokers who encourage you to overconcentrate your portfolio in a singular kind of exchange-traded fund, particularly if they are leveraged. Our highly rated investment fraud attorneys have represented investors against brokers and brokerage firms in FINRA arbitration claims relating to exchange-traded funds. Any investors who have lost money from their financial professional’s recommended exchange-traded funds should contact our experienced investment fraud attorneys for additional assistance and information.