Surprise! Wall St. Journal Agrees Us on ETFs
Investors who got sold an ETF (Exchange Traded Fund) that they didn’t quite understand, especially one that was going to make them money whether the market went up or down, should really pay attention to their statements. The quality of the product and their suitability varies tremendously.
Our friends at FINRA are concerned. We can be far more blunt–inverse and leveraged ETFs can be a bizzaro world full of technical sounds signifying the fury of lost savings and staggering costs.
In June 2009, FINRA issued Regulatory Notice 09-31 to remind firms of their sales practice obligations relating to leveraged and inverse exchange-traded funds (ETFs). At the same time, the Investment Industry Regulatory Organization of Canada (IIROC) issued guidance to the Canadian industry that is substantially similar to our Notice. In July we released a compliance podcast concerning the Notice and some of the issues that it raised. On August 18, 2009, the Securities and Exchange Commission and FINRA issued an Investor Alert to address concerns that investors—particularly buy-and-hold investors—may not understand the performance objectives and risks of these non-traditional ETFs. State regulators also have expressed concerns about the manner in which these funds are sold to investors.
Given the attention that this issue has generated, FINRA is publishing the following frequently asked questions concerning leveraged and inverse ETFs.
Q. What are leveraged or inverse ETFs?
A. The shares of an ETF commonly represent an interest in a portfolio of securities that track an underlying benchmark or index. A leveraged ETF generally seeks to deliver multiples of the daily performance of the index or benchmark that it tracks. An inverse ETF generally seeks to deliver the opposite of the daily performance of the index or benchmark that it tracks. Inverse ETFs often are marketed as a way for investors to profit from, or at least hedge their exposure to, downward-moving markets. Some ETFs are both inverse and leveraged, meaning that they seek a return that is a multiple of the inverse performance of the underlying index. To accomplish their objectives, leveraged and inverse ETFs use a range of investment strategies, including swaps, futures contracts and other derivative instruments.
Q. How can the “reset” feature of a leveraged or inverse ETF affect suitability?
A. Most leveraged and inverse ETFs reset each day, which means they are designed to achieve their stated objective on a daily basis. With the effects of compounding, over longer timeframes the results can differ significantly from their objective. Please see Regulatory Notice 09-31 and the SEC/FINRA Investor Alert for illustrations of how these discrepancies can occur.
Because they reset each day, leveraged and inverse ETFs typically are inappropriate as an intermediate or long-term investment. They may be appropriate, however, if recommended as part of a sophisticated trading or hedging strategy that will be closely monitored by a financial professional. At times, these strategies might justify a decision to hold a leveraged or inverse ETF longer than one day. However, a registered representative must carefully address the question of how to engage in these strategies in a manner consistent with the suitability rule.
Q. What does the suitability analysis require?
A. NASD Rule 2310 (Recommendations to Customers) requires that, before recommending the purchase, sale or exchange of a security, a firm must have a reasonable basis for believing that the transaction is suitable for the customer to whom it is recommended. This is a two-step determination. First, the firm must determine if the product is suitable for anycustomer. To do this, a firm and its associated persons must fully understand the products and transactions that it recommends. This requires an understanding of all terms and features. In the case of a leveraged or inverse ETF, these questions include consideration of how the fund is designed to perform, how it achieves that objective, the impact on performance from market volatility, the use of leverage and the appropriate holding period.
Once a product is determined to be generally suitable for at least some investors, a customer suitability analysis must be performed. With it, a firm must determine if the product is suitable for a specific customer that it may be recommended to. This analysis includes making reasonable efforts to get information on the customer’s financial and tax status, investment objectives and other information deemed reasonable to make the determination.
Q. Can leveraged and inverse ETFs be suitable for a retail investor?
A. While it is not FINRA’s position that all leveraged and inverse ETFs are unsuitable for all retail customers, firms that recommend them must carefully consider their suitability for each customer. Of particular concern, in light of their reset feature, is whether one is recommended as an intermediate or long-term investment rather than as part of a closely monitored trading or hedging strategy.
http://www.finra.org/Industry/Regulation/Guidance/P119781
Check out what Karen Damato had to say in the WSJ
Not every investor has figured out what exchange-traded funds are. But that’s OK. The companies selling them can’t agree either.
A war of words erupted last month when the biggest manager of ETFs, BlackRockInc., proposed stripping the ETF label from some of its competitors’ bread-and-butter products.
The company behind the iShares line of ETFs took particular aim at the industry’s most controversial offerings, which it has shunned: leveraged funds that aim to deliver double or triple the daily moves of a benchmark like the Standard & Poor’s 500-stock index. Ditto for inverse and inverse-leveraged funds that move in the opposite direction to a benchmark.
There’s no question that these volatile portfolios are exchange-traded—giving them the “ET” of ETF—and are regulated as “investment companies,” for the “F.” But BlackRock would rechristen them as “exchange-traded instruments,” or ETIs, and would restrict the ETF label to funds that “can be appropriate for a long-term retail investor,” the company said in a position paper and congressional testimony.
The leveraged funds are meant for short-term trading only and can rack up unexpectedly big losses over time.
BlackRock’s proposal raised some eyebrows and some hackles. Stripping the ETF label from these supercharged ETFs “would be like telling Ferrari [its cars] couldn’t be called ‘automobiles’ because they can exceed 150 mph,” quipped Tom Lydon, editor of ETFtrends.com, in an online comment. He’s also on the board of several leveraged ETFs and funds under the Rydex/SGI banner.
At ProShare Advisors LLC, the biggest seller of leveraged and inverse ETFs, Chief Executive Officer Michael Sapir says the BlackRock idea “is just plain arbitrary and unworkable,” requiring judgment calls about which ETFs are appropriate for whom. He says it’s “anticompetitive,” too, since the proposal would largely redefine products offered by BlackRock competitors.
BlackRock says 228 of its 232 iShares—98%—would still qualify as ETFs under its proposed new nomenclature. A few iShares funds that invest primarily in derivatives or in precious metals would be reclassified as ETIs or as exchange-traded commodities (ETCs).
BlackRock’s concern is that problems at some of the higher-risk ETFs could potentially give the whole category a black eye. If investors are burned by leveraged ETFs, “there is potentially a downside not just for our company but for the entire financial-services industry,” says Jennifer Grancio, head of iShares global business development.
Sellers of leveraged ETFs say they have no beef with expanded disclosure and education for investors. But after a couple of years in which the media and regulators have warned repeatedly about the hazards of leveraged ETFs, Dan O’Neill, managing director of Rafferty Asset Management LLC, which sponsors the Direxion Shares leveraged funds, also says he believes most investors in these ETFs “understand these products and use them wisely.”
In any event, there’s still plenty of room for confusion about other types of vehicles besides leveraged funds that can be grouped under the very popular ETF banner. Two key areas:
- In common parlance and performance listings, exchange-traded notes are often lumped in with ETFs. While funds own stocks or other assets, ETNs are debt instruments whose returns are pegged to the return on stocks or other assets. Investors could be up a creek if an ETN issuer defaults; on the other hand, the tax treatment and benchmark tracking may beat an ETF.
- Just as investors in most mutual funds and ETFs don’t realize they are technically buying shares in an “investment company,” investors in commodities ETFs and some other ETFs may not realize they are investing in portfolios that are set up as trusts or limited partnerships. These are “funds” in the common sense of being portfolios that pool investor dollars to buy assets. But some structures can have a big downside: more complex tax reporting.
http://online.wsj.com/article/SB10001424052970204644504576651050423590720.html
