Exchange Traded Funds Basics

Central Florida Investment Fraud and Misrepresentation Lawyer — Russell L. Forkey

Frequently, an attorney’s website contains information that makes us assume that all investors have a general working knowledge of the markets and the fundamental investments that are traded thereon. If this is you, then most likely it will not be necessary for you to read this post other than to scan it to possibly refresh your memory. If, on the other hand, you have never invested before or consider yourself a novice, we strongly urge you to take the time to read the below described information. If you have any questions, please feel free to contact us for an initial free consultation. The below described information should not be considered a legal or investment advice but is being provided for educational purposes only.

Exchange Traded Funds

An Exchange Traded Fund (ETF) is an investment product that allows an investor to buy and sell shares in a single security that represents fractional ownership of a portfolio of securities. Legally, ETFs are open-ended investment companies or unit investment trusts that are registered under the Investment Company Act of 1940.

The very first ETF, which tracked the S&P 500 Index, was traded in 1993 on the Amex. Since then over 700 ETFs have been introduced into the market place that allow investors to gain exposure to a wide range of investment strategies including broad stock indexes, industry sectors, fixed income indexes and international and global indexes. Recently, ETFs have introduced investment objectives that attempt to replicate a multiple or the inverse of the daily return of an underlying index. Another new type of investment offered in the ETF structure is the actively managed portfolio. Unlike traditional ETFs, which are designed to track an index, actively managed ETFs permit the fund manager to buy and sell securities and derivatives according to a stated strategy, described in the prospectus. As a condition of operations, the portfolio or fund holdings are disclosed daily on the fund’s website.

ETFs are one type of structured exchange-traded product. There are other types as well, but they do not share all the characteristics of ETFs, even though they may be referred to as such in the popular press and on some websites. Examples of these other investment products include exchange traded notes (ETNs), equity linked notes, closed-end funds and exchange traded vehicles (ETVs), among others. These products are not discussed herein. They are being mentioned so the investor is not confused if these products are mentioned in a discussion with your financial professional.

Also, not being discussed herein are ETFs that offer leverage or that are designed to perform inversely to the index or benchmark they track or both are growing in number and popularity. However, as noted in FINRA Regulatory Notice 09-31: “While such products may be useful in some sophisticated trading strategies, they are highly complex financial instruments that are typically designed to achieve their stated objectives on a daily basis. Due to the effects of compounding, their performance over longer periods of time can differ significantly from their stated daily objective. Therefore, inverse and leveraged ETFs that are reset daily typically are unsuitable for retail investors who plan to hold them for longer than one trading session, particularly in volatile markets.”

The good thing about ETFs is that they are offered by prospectus, which is supplemented from time to time. As we have continuously stated on this site, it is important for the investor to make sure that he or she reads and fully understands what is contained in the prospectus and supplements. Anything that you do not understand should be brought to the attention of your financial professional for further explanation.

Many prospects contain a “summary” section that provides a quick snapshot of what is explained further in the document in more detail. If the prospectus contains a summary section, it usually will provide the reader with the following information:

  • The investment objective of the fund
  • The fees and expenses of the fund
  • Portfolio turnover
  • Principal investment strategies
  • Principal risks
  • Investment results or performance
  • Who the investment adviser is
  • Who the portfolio managers are
  • How the fund shares are purchased and sold
  • Tax information

All investors, but especially seniors, should pay attention to the principal risks associated with the particular ETF being considered. Just by way of example, let’s say you are looking at a broad market EFT some of the risks that might be mentioned are:

  • Market risk
  • Investment style risk
  • Securities Lending risk
  • Liquidity risk
  • Derivatives risk
  • Equity risk
  • Large-cap and mid-cap risk
  • Sampling index tracking risk
  • Securities lending risk
  • Concentration risk

As with other types of investment, ETFs that are recommended to you by your financial professional must meet the general suitability requirements established by FINRA. Consequently, your broker should not recommend an ETF to you if he or she knows that it is not suitable for you. This suitability requirement would also apply to the frequent buying and selling of these products.

If you elect to invest in ETFs, you trade them just like a stock. You place a buy or sell order with your broker, and he or she fills the order for you, adding the securities to your account when the transaction is closed. Whenever the market is open, you can make a trade. And just like stock orders, you can add conditions to your ETF trading orders. For example, you can place a limit order for an ETF, just like you would for a stock.

If you believe that you have suffered damages as a result of broker fraud, misrepresentation or other misconduct from your purchase or sale of an EFT, please call for your initial free consultation.

Contact Us

With extensive courtroom, arbitration and mediation experience and an in-depth understanding of securities law, our firm provides all of our clients with the personal service they deserve. Handling cases worth $25,000 or more, we represent clients throughout Florida and across the United States, as well as for foreign individuals that invested in U.S. banks or brokerage firms. Contact us to arrange your free initial consultation.

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