FINRA warns about leveraged, inverse ETFs

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FINRA (the Financial Industry Regulatory Authority) has warned financial services firms that non-traditional exchange-traded funds (ETFs) are unsuitable for retail investors who plan to hold them for more than one day (a trading session), particularly in volatile markets. Let’s examine why FINRA has taken an interest in leveraged and inverse ETFs.

Preliminarily, certain ETFs trade throughout the day on exchanges just like stocks. Leveraged ETFs usually are labeled “Ultra”, “2X” or “3X” because they deliver multiples of the performance of the index or benchmark that they track. An “inverse” ETF seeks to return the opposite of (or multiples of the opposite of) the performance of the index or benchmark that it tracks. ETFs accomplish those objectives through the use of swaps, futures contracts and other derivative instruments.

While FINRA concedes that such ETFs have grown in number and in popularity, and “may be useful in some sophisticated trading strategies”, the ETFs nonetheless are “highly complex financial instruments.” One of FINRA’s major concerns is the effect of compounding. Specifically, most leveraged and inverse ETFs achieve their stated objectives (or “reset”) daily. However, ETFs that are held longer can be quite risky. FINRA warns that, “Due to the effect of compounding, their performance over longer periods of time can differ significantly from the performance (or inverse of the performance) of their underlying index or benchmark during the same period of time.”

To illustrate, FINRA provides the following example of actual performance: an ETF seeking to deliver three times the daily return of the Russell 1000 Financial Services Index fell 53 percent while the actual index actually gained about 8 percent, and the related ETF seeking to deliver three times the inverse of the index’s daily return declined 90 percent over the same period! FINRA cautions that the effect “can be magnified in volatile markets.”

Accordingly, FINRA’s Regulatory Notice 09-31 focuses upon four areas: suitability, communications with the public, supervision, and training of personnel. Regarding the suitability of leveraged and inverse ETFs, FINRA reminds firms that they “must understand the terms and features of the funds, including how they are designed to perform, how they achieve that objective, and the impact that market volatility, the ETF’s use of leverage, and the customer’s intended holding period will have on their performance.”

In addition to warning firms that the ETFs are not suitable for investors planning to hold them for more than one trading session (a day), especially in volatile markets, FINRA reminds firms that, in determining suitability, they have an obligation to familiarize themselves with the customer’s “financial situation, trading experience, and ability to meet the risks involved with such products.”

Second, regarding communications with the public, FINRA cautions that firms must “make every effort to make customers aware of the pertinent information” regarding leveraged and inverse ETFs. The picture presented must be “fair and balanced.”

In particular, FINRA states: “an advertisement for a leveraged or inverse ETF that is designed to achieve its investment objective on a daily basis may not omit that fact and must specifically disclose that the fund is not designed to, and will not necessarily, track the underlying index or benchmark over a longer period of time.” The regulatory notice also reminds firms that “providing risk disclosure in a prospectus or product description does not cure otherwise deficient disclosure in sales material, even if the sales material is accompanied by or preceded by the prospectus or product description.”

Finally, regarding supervision and training, FINRA reminds firms that they must establish written supervisory procedures, and that, in addition, they must document compliance with those procedures.

For training, FINRA recommends that firms emphasize the need to understand and consider the risks associated with leveraged and inverse ETFs, “including the investor’s time horizons, and the impact of time and volatility on the fund’s performance.” FINRA warns that financial advisers must understand that ETFs “may not perform over time in direct or inverse correlation to their underlying index”, and that this fact may be important to investors who “may be turning to these funds as part of a long-term strategy to weather current market conditions.”

As one can see, leveraged and inverse ETFs are not for the faint of heart. At best, they serve an extremely limited function for investors. Anything more than that is asking for trouble.