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SEC sends contradictory compliance message in approving 4x leveraged ETFs
May 19, 2017 / 5:47 PM / 5 months ago

SEC sends contradictory compliance message in approving 4x leveraged ETFs

People walk past the New York Stock Exchange on Wall Street, February 10, 2009.

NEW YORK (Thomson Reuters Regulatory Intelligence) - The U.S. Securities and Exchange Commission’s approval of an application to trade a pair of quadruple-leveraged exchange-traded funds (ETFs) signaled that last year’s proposed rule limiting the use of derivatives and leverage in mutual funds and ETFs may be essentially dead.

The approval earlier this month of such a volatile and risky product sent a message contradictory to the warnings and enforcement efforts by the SEC as well as the Financial Industry Regulatory Authority (FINRA) to protect investors from complex, and unsuitable product sales.

The agency has repeatedly warned of the dangers of leveraged and complex products, and its enforcement division announces case after case of inappropriate sales of such products. But the leveraged ETFs are arguably the most volatile and riskiest products the SEC has approved.

Now, the commission is apparently having second thoughts about its green light for the potentially risky funds.

Reuters reported this week, the full commission plans to review the initial decision by staff members to allow quadruple-leveraged ETFs to come to market. It was not immediately clear what issues sparked the review. The SEC and the exchange planning to market the funds declined to comment and the product’s distributor could not immediately be reached. The SEC could reverse or uphold the initial staff decision pending a more complete review, people familiar with the matter said.

If the “4x ETFs” are eventually approved, compliance departments, product review committees, and sales supervisors must ensure such products are handled and sold with the utmost caution, and be prepared for more of these risky products which are likely to come.

Below we review the products, the regulatory picture, recent regulatory actions and warnings surrounding their sales, and offer compliance suggestions.

PROPOSED RULES LIMITING DERIVATIVES AND LEVERAGE IN FUNDS LIKELY DEAD

Regulators have historically discouraged the use of derivatives to create leverage, but there has been no actual prohibition. In 2015 the SEC proposed a rule (here), which would require all funds to document and implement a derivatives risk management program. Around 80 percent of funds are believed to use derivatives for hedging purposes, so the rules would affect nearly every fund manager. However, alternative funds and leveraged funds would have been forced to dramatically alter their strategy or shut down under the proposed rule.

The proposal was part of a broader SEC effort to increase investor protection and mitigate systemic risk by modernizing the Investment Company Act of 1940. The SEC said in a 2015 press release (here) that the proposed rules are "designed to modernize the regulation of funds' use of derivatives and safeguard both investors and our financial system."

Former SEC Chair Mary Jo White, identified finalizing the derivatives rule as a priority but the proposal was left unfinished. Former interim Chair Michael Piwowar voted against releasing the derivatives proposal. The views of newly confirmed Chair Jay Clayton on the rule are unclear, but with Piwowar still on board as a commissioner, the rule is unlikely a priority of the SEC’s Republican majority.

Therefore the proposed rules are now likely dead or at the very least in limbo as the SEC likely changes course under a deregulation-minded administration.

MORE LEVERAGE AND RISK FOR RETAIL INVESTORS

The request to list ForceShares Daily 4X US Market Futures Long Fund, and ForceShares Daily 4X US Market Futures Short Fund was filed by Intercontinental Exchange Inc’s NYSE Arca exchange. One of the funds is designed to deliver 400 percent of the daily performance of S&P 500, while another fund will aim to deliver four times the inverse of the benchmark.

ETFs offering three times leverage already trade in the United States, but the question now becomes how much leverage is too much and where does the regulator draw the line? Opponents worry that the temptation of such outsized returns will be difficult to resist, and investors are sure to end up on the losing end.

So for whom is the product suitable for? Perhaps only the most nimble and sophisticated day-traders or institutions, is what the regulators say. However, most sophisticated traders and institutions already accomplish this objective through the use the futures market. Therefore, what the regulator has done is essentially created a leveraged futures product and listed it on the stock exchange so any investor can buy it just like any common stock.

LEVERAGED AND INVERSE ETF‘S...IT‘S ALL MATH

Leveraged funds seek double, triple, and now even quadruple the daily percentage move in either direction, up or down of a particular index. On a daily basis the funds often achieve this objective. However, when held for more than a day, the math gets messy and it often becomes nearly impossible for the investor to come out ahead. Over longer periods of time, the performance of these funds often differs dramatically from the indexes they are designed to track and therefore must be handled with extreme caution.

In order to understand the discrepancy between daily returns and long-term returns one must understand the difference between the arithmetic and geometric means and understand the positive and negative effects of compounding. Anytime one compounds a negative return, its impact is always more pronounced than a positive compounding of the same magnitude.

Morningstar has published (here) a widely circulated and essential article explaining the math behind leveraged and inverse fund performance.

REGULATORY WARNINGS ON LEVERAGED ETF‘S

The SEC has repeatedly warned firms and the investing public of the dangers associated with this type of ETF. In 2009 the regulator along with FINRA issued an investor alert which prominently warned of the inherent risk.

In its 2017 exam priorities letter (here) the SEC said it will continue to focus on ETF sales strategies, trading practices and disclosures, and the suitability of broker-dealers’ recommendations to purchase ETFs with niche strategies.

FINRA, in its 2017 exam priorities (here) warned of the dangers with the products. "Calls to the FINRA Securities Helpline for Seniors (HELPS)[here], have exposed troubling scenarios of senior and unsophisticated investors buying into sales pitches for speculative energy- based investments," FINRA said. "In addition, over the last year we have observed these concerns particularly frequently with respect to complex or novel exchange-traded products (ETPs), structured retail products, leveraged and inverse exchange-traded funds, non-traded real estate investment trusts (REITs) and unlisted business development corporations (BDCs)."

RECENT ENFORCEMENT ACTIONS INVOLVING SIMILAR PRODUCTS

Sales practices surrounding these alternative strategy funds, also sometimes referred to as "liquid alts," as well as leveraged and inverse ETFs now appear to be in the crosshairs of regulators. Earlier this year the SEC announced (here) Morgan Stanley Smith Barney agreed to pay $8 million to settle charges related to single inverse exchange-traded fund investments that the firm had recommended to clients.

In the statement, the SEC said Morgan Stanley admitted to wrongdoing, adding that the company had from 2010 to 2015 “recommended securities with unique risks and failed to follow its policies and procedures to ensure they were suitable for all clients.”

“Morgan Stanley solicited clients to purchase single inverse ETFs in retirement and other accounts, the securities were held long-term, and many of the clients experienced losses,” the SEC said.

According to the settlement (here), Morgan Stanley failed to obtain from several hundred clients a signed client disclosure notice, which stated that single inverse ETFs were typically unsuitable for investors planning to hold them longer than one trading session.

Last year FINRA fined Oppenheimer & Co. Inc. $2.25 million and ordered the firm to pay restitution of more than $716,000 to affected customers for selling leveraged, inverse and inverse-leveraged exchange-traded funds to retail customers without reasonable supervision, and for recommending non-traditional ETFs that were unsuitable.

In the settlement announcement (here) FINRA said, "Oppenheimer instituted policies prohibiting its representatives from soliciting retail customers to purchase non-traditional ETFs, and also prohibiting them from executing unsolicited non-traditional ETF purchases for retail customers unless the customers met certain criteria, e.g., the customer had liquid assets in excess of $500,000." However, the firm failed to "reasonably enforce these policies."

“From August 2009 through September 30, 2013 more than 760 Oppenheimer representatives executed more than 30,000 non-traditional ETF transaction totaling approximately $1.7 for customers,” according to the statement.

COMPLIANCE REMINDERS, BEST PRACTICES AND SUGGESTIONS FOR FIRMS

Ethical sales practices and adequate risk disclosures have always been core principles in the retail investment advice and the brokerage business. Brokers must fully understand the products they sell, and must ensure their clients also fully understand the risks associated with the investments. Monitoring these activities and enforcing policies and procedures is the responsibility of compliance departments.

Training of sales personnel is critical. If a product is so complex an adviser is unable to understand and articulate the risks to customers, it most likely is not suitable for retail investors.

Product review committees must screen and review complex products and work with compliance to restrict sales. Simple risk disclosures often fall on deaf ears, so greater steps must be taken in some instances. Issuing an outright restriction or ban of the sales of some products is a step many firms have taken.

Constant supervision and monitoring of the complex-product sales is a necessity. Compliance must work with IT departments to monitor transactions and to flag holdings of unsuitable products.

In the Morgan Stanley case, the SEC stated, “Morgan Stanley recommended securities with unique risks and failed to follow its policies and procedures to ensure they were suitable for all clients.” This should be seen as a warning to firms to be sure to monitor and police its own policies and procedures.

Written procedures are worthless unless accompanied by a program to enforce them. Policies prohibiting solicitation of non-traditional ETFs must be supplemented by a meaningful compliance effort to enforce them.

Compliance and risk departments must exercise the utmost caution when a regulator sends mixed messages. Despite hints and signs of regulatory rollback and allowing the creation of such risky products like leveraged ETFs on one hand, other parts of the SEC, including the enforcement division, shows no sign of letting up in enforcing the rules. Compliance departments should not be lulled into a false sense of security that the regulator is easing when other regulators or even other divisions of the same regulator may not be.

(Todd Ehret is a Senior Regulatory Intelligence Expert for Thomson Reuters Regulatory Intelligence. He has more than 20 years’ experience in the financial industry where he held key positions in trading, operations, accounting, audit, and compliance for broker-dealers, asset managers, and hedge funds.)

This article was produced by Thomson Reuters Regulatory Intelligence and initially posted on May. 8. Regulatory Intelligence provides a single source for regulatory news, analysis, rules and developments, with global coverage of more than 400 regulators and exchanges. Follow Regulatory Intelligence compliance news on Twitter: @thomsonreuters

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