From time to time, I’ve been asked: “I hear of exotic alternative investments that can make money even when the market is falling. Do you recommend these?”
Exotic investments, which have been made available to the general public through ETFs, can land unwary investors in plenty of hot water. These exotic investments can carry very high risks for the unsophisticated. Federal and industry regulators are warning investors to beware.
ETFs, or exchange traded funds, are similar to mutual funds—they are pooled investments in a portfolio of securities. As investment vehicles, ETFs are sound when representing underlying index or asset classes.
On the other hand, leveraged and inverse ETFs use a host of exotic investment strategies, including swaps, futures contracts and other derivatives.
Leveraged ETFs try to achieve double or triple the performance of the underlying indexes they invest in.
Inverse ETFs try to rise or fall in the opposite direction of their underlying index. In other words, they try to go up when the index falls.
Leveraged inverse ETFs try to double or triple in inverse relationship to the index.
These ETFs are designed to deliver that performance on a daily basis only. Their performance over weeks or months can differ significantly from the index, even to the point where an investor in the index would have made money but the investor in the ETF would have lost money.
For example, one ETF index returned 2% from December 2008 through April 2009. Yet the leveraged ETF, which sought to return twice the index’s return, fell by 6%. And the inverse ETF, which sought to profit when the index fell, actually plummeted by 26%.
Some investment firms have criticized these types of ETFs, calling them booby traps for average investors. We do not endorse leveraged or inverse ETFs. We do recommend index funds and ETFs that are designed to reflect the investment results of the underlying index or asset class.
Don’t get greedy. Instead control your risks and pursue potential rewards by developing an appropriate investment allocation that you can live with through the inevitable ups and downs of the markets. Take advantage of market fluctuations by periodically rebalancing your portfolio back to your risk-appropriate investment allocation. By staying fully invested with this systematic, proactive strategy, you historically have had an excellent opportunity to earn competitive returns to achieve and maintain financial independence throughout your retirement years.
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