Mutual Funds and Exchange Traded Funds (ETFs)

Over the last few years, investor disputes involving mutual funds and exchange traded funds (ETFs) have surpassed those involving individual stocks or securities.

Investor Alert: Leveraged and Inverse ETFs and Mutual Funds

Recently, there has been a surge in investor complaints involving leveraged and inverse funds. Leveraged and inverse funds, such as those offered by ProFunds and ProShares, promise potential returns that are double or triple that of their index or benchmark. However, leveraged and inverse funds are risky and volatile investments that can magnify an investors losses. They are entirely unsuitable for long–term investors [Visit our blog for more information about leveraged and inverse ETFs].

Mutual Funds

Mutual funds are professionally managed investment pools that can invest in almost any kind of securities, particularly stocks and bonds. A stock fund can invest in a broad diversified index such as the Standard and Poor 500 (S&P 500) or in narrow sectors such as utilities and biotechnology. A bond fund's investments can range from “investment grade” bonds to riskier non-investment grade bonds often called high-yield bonds or “junk bonds.” As is the case with recommending securities, a stockbroker or investment advisor has a fiduciary duty to only recommend suitable mutual funds. Often the name of the mutual fund can be deceiving any many customers have been misled into purchasing funds that were much riskier than the customer wanted or needed.

The various types of funds available can be confusing. Mutual funds come in two varieties: no load funds and load funds. “Load” refers to the sales commission. For obvious reasons, stockbrokers and investment advisors prefer to recommend load funds to their clients. In the case of a front-end load, a commission is charged at the time of purchase. Conversely, a fund with a back-end load only charges a commission at the time of sale, known as a “contingent deferred sales charge” (CDSC). A CDSC acts as an early surrender penalty that applies whenever a customer fails to hold the fund long enough―sometimes 6 years or longer.

To further confuse matters, mutual funds also come in a variety of classes. The most common classes are “Class A,” “Class B” and “Class C” shares. Class A shares typically charge a front-end load while Class B shares charge a back-end load. Class A shares, however, are eligible for “breakpoints” or a discount on the sales commission if a large enough order if placed. A stockbroker may not place a trade that is just below the “breakpoint” in order to earn a higher commission. Class C shares do not charge a load; however, they make up for this by imposing higher administrative fees. A stockbroker or investment advisor is obligated to recommend the most appropriate class to their customers based on each customer’s particular investment goals and objectives. Recommending the wrong mutual fund class to a customer could cause them to pay unnecessary sales commissions or be assessed early withdrawal penalties.

Exchange Traded Funds (ETFs)

The marketing and sale of exchange traded funds (ETFs) has grown exponentially in the past few years. A stockbroker or investment advisor has a fiduciary duty to recommend ETFs that are suitable based on the customer’s financial goals and objectives. ETFs can invest in a wide variety of securities such as domestic and international stocks indices, industry sectors and fixed-income indices. There are also actively managed ETFs that rely on a professional investment manager to buy and sell securities according to a prescribed investment strategy. There are also leveraged and inverse ETFs that employ shorting and derivative strategies to achieve their objectives. Leveraged and inverse ETFs are complicated products with increased risk that may be unsuitable for many investors.

Unlike traditional mutual funds, ETFs do not have different classes of shares. Instead, ETFs are traded throughout the day like stocks and each purchase and sale carries a brokerage fee or sales commission just as individual stocks do. Because ETFs charge a management fee that is deducted from the net asset value, a stockbroker or investment advisor must consider the total cost to the investor when recommending the purchase of ETFs.