A just-announced fine levied by the Financial Industry Regulatory Authority against two broker-dealers for improper sales of leveraged and inverse ETFs is highlighting the need for BD reps to brush up on their knowledge of these products, and which clients they’re suitable for.
FINRA announced Thursday that it has ordered two St. Louis-based broker-dealers — Stifel, Nicolaus & Co. Inc. and Century Securities Associates Inc.— to pay combined fines of $550,000 and a total of nearly $475,000 in restitution to 65 customers in connection with sales of leveraged and inverse ETFs.
Brad Bennett, FINRA’s executive vice president and chief of enforcement, warned in announcing the fine that “the complexity of leveraged and inverse exchange-traded products makes it essential for securities firms and their representatives to understand these products before recommending them to their customers.” Firms, he said, must also conduct “reasonable due diligence on these and other complex products, sufficiently train their sales force and have adequate supervisory systems in place before offering them to retail investors.”
In 2013, FINRA brought 19 cases involving ETFs with fines totaling more than $1.5 million and restitution of nearly $780,000.
Two recent fines that were levied involving leveraged and inverse ETFs include FINRA’s order in December that J.P. Turner pay more than $700,000 in restitution for unsuitable sales of the funds and for excessive mutual fund switching. FINRA also fined in May 2012 Citigroup Global Markets Inc., Morgan Stanley & Co. LLC, UBS Financial Services and Wells Fargo Advisors LLC a total of more than $9.1 million for selling leveraged and inverse ETFs without reasonable supervision and for not having a reasonable basis for recommending the securities.
Leveraged and inverse ETFs “reset” daily, meaning that they are designed to achieve their stated objectives on a daily basis so their performance can quickly diverge from the performance of the underlying index or benchmark, FINRA explains. “It is possible that investors could suffer significant losses even if the long-term performance of the index showed a gain,” the regulator says. “This effect can be magnified in volatile markets.”
Between January 2009 and June 2013, FINRA found that Stifel and Century made unsuitable recommendations of nontraditional ETFs to certain customers because some reps “did not fully understand the unique features and specific risks associated with leveraged and inverse ETFs.” Customers with conservative investment objectives who bought one or more nontraditional ETFs based on recommendations made by the firms’ representatives, and who held those investments for longer periods of time, experienced net losses.
FINRA also found that Stifel and Century did not have reasonable supervisory systems in place, including written procedures, for sales of leveraged and inverse ETFs. The two firms generally supervised transactions in those funds in the same manner that they supervised traditional ETFs, and neither firm created a procedure to address the risk associated with longer-term holding periods in the products.
Stifel and Century neither admitted nor denied the charges but consented to the entry of FINRA’s findings.
Stifel agreed to pay a fine of $450,000 and to make restitution of nearly $340,000 to 59 customers. Century agreed to pay a fine of $100,000 and to make restitution of more than $136,000 to six customers.
Ron DeLegge, founder of ETFGuide and a ThinkAdvisor blogger, says that brokers “won’t figure out how to correctly implement an investment strategy with leverage and inverse ETFs until they first identify customer investor personalities. It’s that simple.”
He adds: “A lack of rigorous client suitability and understanding is the actual problem, not leverage and inverse ETFs.”
Indeed, ETFGuide noted in a recent article that clients with “a very short investment time horizon of just a few days” are probably best suited for “leveraged and short ETFs.” However, the article warned that “investors that want to bet on the long-term gains or losses of a particular asset class or industry sector should probably not be using daily leveraged and short ETFs. It’s that simple.”
Michael Rawson, CFA and fund analyst at Morningstar, told ThinkAdvisor he agreed that leveraged and inverse ETFs “are complex products and not appropriate for most long-term investors.”
He said that FINRA cautioned its broker members against the sale of these products as far back as June 2009, and that the “SEC raised the possibility that these products need additional investor protections.”
While Rawson doesn’t foresee “a bright future” for these types of ETFs, he said that “there is a legitimate use for them among traders, speculators and hedgers. However, they require greater education and monitoring than a typical product that I would recommend to the average investor.” He adds: “Several brokerage firms have restrictions in place to make it more difficult for their brokers to use these funds for clients.”
Check out Volatility, Anyone? by Ron DeLegge on ThinkAdvisor.