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Which type of risk would a registered representative be least likely emphasize to their clients about inverse leveraged ETFs?
A. The underlying securities of leveraged ETFs are more likely to default
B. Managers rely on complicated investment strategies such as derivatives, swaps, and futures contracts that can lead to high volatility in returns
C. They are designed to meet their goals on a daily basis, and their goals are reset daily which can lead to large tracking errors
D. The fund is betting the opposite direction of the market that they are tracking
Correct Answer: A.
Rationale: Leveraged exchange traded funds (ETFs) are ETFs that try to deliver a multiple of the performance of the index or benchmark that they track. For example, if the S&P 500 returned 2% in a day, a leveraged ETF’s objective might be to return 4%. Some leveraged ETFs are “inverse” or “short” funds, meaning the leveraged ETF is seeking to deliver a multiple of the opposite performance of the tracked index. In order to achieve the high required returns, the managers rely on complicated investment strategies such as derivatives, swaps, and futures contracts. Another risk of leveraged ETFs is that they are designed to meet their goals on a daily basis, and their goals are reset daily. This strategy can compound gains and losses, leading to large tracking errors over time. FINRA gives the following sobering 2009 example, “The Dow Jones U.S. Oil & Gas Index gained 2 percent (over a 5 month period), while an ETF seeking to deliver twice the index’s daily return fell 6 percent and the related ETF seeking to deliver twice the inverse of the index’s daily return fell 26 percent.”
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