As we previously reported, The Financial Industry Regulatory Authority (FINRA) sanctioned brokerage firm World Equity Group, Inc. (World Equity) concerning at least seven different allegations of supervisory failures that occurred between 2009 through 2012. These failures included failures to implement an adequate supervisory system reasonably designed to detect and prevent potential rule violations concerning both internal processes and procedures and in the handling of customer accounts in the areas of suitability of transactions in non-traditional ETFs, private placements, and non-traded REITs.
FINRA alleged that World Equity failed to implement an adequate system to ensure the suitability of Non-Traditional ETFs. As a background, Non-Traditional ETFs are registered unit investment trusts or open-end investment companies whose shares represent an interest in a portfolio of securities that track an underlying benchmark, index, commodity, or other instrument. Shares of ETFs are typically listed on national exchanges and trade at established market prices. Non-Traditional ETFs are different from traditional ETFs in that they return a multiple of the performance of the underlying index or benchmark or the inverse performance.
Non-Traditional ETFs may use swaps, futures contracts, and other derivative instruments in order to create leverage to achieve these objectives. In addition, most Non-Traditional ETFs are designed to achieve their stated objectives in one trading session. Between trading sessions the fund manager generally rebalances the fund’s holdings in order to meet the fund’s objectives. For most Non-Traditional ETFs the rebalancing happens on a daily basis. Further, because the correlation between a Non-Traditional ETF and its linked index or benchmark is inexact there is typically tracking error between a fund and its benchmark becomes compounded over longer periods of time. In addition, the tracking error effect becomes more pronounced during periods of volatility in the underlying index or benchmark. FINRA advised brokerage firms in June 2009 due to the effect of compounding the performance of Non-Traditional ETFs over longer periods of time can differ significantly from the performance of their underlying index or benchmark during the same period of time and because of these risks and the inherent complexity of the products, FINRA advised broker-dealers and their representatives that the products are typically not suitable for retail investors who plan to hold them for more than one trading session.
In addition, FINRA has stated that brokerage firms selling Non-Traditional ETFs must train registered persons about the terms, features, and risks as well as the factors that would make such products either suitable or unsuitable for certain investors. The training should emphasize the need to understand and consider the risks associated with Non-Traditional ETFs including the investor’s time horizons, and the impact of time and volatility on the fund’s performance.
In the case of World Equity, FINRA found that from January 2009, to July 2012, there were over 100 Non-Traditional ETFs that were held more than 1 trading day, yet those transactions were not
flagged for review. In addition, FINRA found that the explanations of the recommendations by the representatives indicated a lack of understanding of the holding periods. FINRA found that some brokers indicated that the period was to be a year, or was to be reviewed quarterly. As a result, FINRA found that the firm failed to have a system in place to ensure the suitability of Non-Traditional ETFs.
To be continued…
Investors who have suffered losses may be able recover their losses through securities arbitration. The attorneys at Gana LLP are experienced in representing investors in cases of unsuitable investments in Non-Traditional ETFs. Our consultations are free of charge and the firm is only compensated if you recover.