Articles Tagged with Inverse ETFs

shutterstock_103476707The Financial Industry Regulatory Authority (FINRA) recently sanctioned brokerage firm Felt & Company (Felt) alleging that between January 2009, and September 2012, Felt failed to establish and supervisory system that was reasonably designed to ensure that sales leveraged or inverse exchange-traded funds (Non-Traditional ETFs) complied with all applicable securities laws.

Feltl is headquartered in Minneapolis, Minnesota, has approximately 114 registered representatives operating out of eight branch offices in Minnesota and Illinois. Felt derives revenue from securities commissions, underwriting, and investment company activity and has been a FINRA member since 1975. This most recent FINRA action is not the first time the regulatory has brought an action concerning issues of how Felt sells securities products to investors. As we previously reported, FINRA sanctioned Feltl and imposed a $1,000,000 fine concerning allegations that the firm, between January 2008, and February 2012. failed to comply with the suitability, disclosure, and record-keeping requirements engaging in a penny stock business.

In the most recent disciplinary action, FINRA alleged that the securities laws requires a firm to have a reasonable basis for believing that a product is suitable for any customer before recommending any purchase of that product. In order to meet this requirement, a firm must understand the terms and features of the product including how they are designed to perform, how they achieve that objective, and the impact that market volatility on the product. In the case of Non-Traditional ETFs the use of leverage and the customer’s intended holding period are significant considerations in recommending these products.

shutterstock_188995727Broker Kenneth Popek (Popek) has had four customer complaints filed against him over his career as a financial advisor. That many claims are rare. According to InvestmentNews, only about 12% of financial advisors have any type of disclosure event on their records. These disclosures do not necessarily have to include customer complaints but can include IRS tax liens, judgments, and even criminal matters. In Popek’s case the broker has four customer complaints and one bankruptcy.

Popek was registered with Ameriprise Financial Services, Inc. from December 2006 until May 2008. Thereafter, Popek was registered and still is registered with Calton & Associates, Inc.

One of Popek’s complaints went to hearing where a panel awarded the customers $342,956 concerning allegations of suitability, misrepresentations, churning, and breach of fiduciary duty. According to the award the causes of action involved, in part, investments in General Motors, Lehman Brothers, and Washington Mutual stocks that all went bust.

shutterstock_161005307The Financial Industry Regulatory Authority (FINRA) sanctioned brokerage firm The Oak Ridge Financial Services Group, lnc. (Oak Ridge) in connection with allegations that Oak Ridge failed to establish and maintain a supervisory system regarding the sale of leveraged, inverse and inverse leveraged exchange-traded funds (Non-Traditional ETFs) that were reasonably designed to achieve compliance with the securities laws.

Oak Ridge became a FINRA member in 1997 and is headquartered in Golden Valley, Minnesota. Oak Ridge engages in a general securities business, employs 57 registered representatives, and operates out of a single office.

Non-Traditional ETFs contain drastically different characteristics, including risks, from traditional ETFs that simply seek to mirror an index or benchmark. Non-Traditional ETFs use a combination of derivatives instruments and debt to multiply returns on underlining assets. The leverage employed by Non-Traditional ETFs is designed not simply to mirror the index but to generate 2 to 3 times the return of the underlining asset class. Non-Traditional ETFs can also be used to return the inverse or the opposite result of the return of the benchmark.

shutterstock_157506896The Financial Industry Regulatory Authority (FINRA) has sanctioned Salomon Whitney, LLC (Salomon Whitney) concerning allegations from July 2008 through November 2009 the firm failed to establish and maintain a supervisory system reasonably designed to monitor transactions in leveraged, inverse, and inverse-leveraged Exchange-Traded Funds (Non-Traditional ETFs). Non-Traditional ETFs contained risks that increase over time and in volatile markets including risks of a daily reset, leverage, and compounding. FINRA found that Salomon Whitney failed to establish a reasonable supervisory system to monitor transactions in Non-Traditional ETFs, provide adequate formal training, and observe reasonable basis suitability guidelines by failing to perform reasonable due diligence to understand the risks and features associated with the products.

Salomon Whitney has been a FINRA broker-dealer since 2008 and the firm is headquartered in Farmingdale, New York where it conducts a general securities business. Salomon Whitney has approximately 19 brokers registered with the firm.

Non-Traditional ETFs use a combination of derivatives instruments and debt to multiply returns on an underlining asset, class of securities, or sector index. The leverage employed by Non-Traditional ETFs is designed to generate 2 to 3 times the return of the underlining asset class. Non-Traditional ETFs can also be used to return the inverse or the opposite result of the return of the benchmark.

A recent statement by BlackRock Inc (BlackRock) Chief Executive Larry Fink concerning leveraged exchange traded funds (Leveraged ETFs) has provoked a chain reaction from the ETF industry. Fink runs BlackRock, the world’s largest ETF provider. Fink’s statement that structural problems with Leveraged ETFs have the potential to “blow up the whole industry one day” have rattled other ETF providers – none more so than those selling bank loan ETFs. Naturally, sponsors of Leveraged ETFs, a $60 billion market, called the remarks an exaggeration.

shutterstock_105766562As a background, leveraged ETFs use a combination of derivatives instruments and debt to multiply returns on an underlining asset, class of securities, or sector index. The leverage employed is designed to generate 2 to 3 times the return of the underlining assets. Leveraged ETFs can also be used to return the inverse or the opposite result of the return of the benchmark. While regular ETFs can be held for long term trading, Leveraged ETFs are generally designed to be used only for short term trading – sometimes as short as a single day’s holding. The Securities Exchange Commission (SEC) has warned that most Leveraged ETFs reset daily and FINRA has stated that Leveraged ETFs are complex products that are typically not suitable for retail investors. In fact, some brokerage firms simply prohibit the solicitation of these investments to its customers, an explicit recognition that a Leveraged ETF recommendation is unsuitable for virtually everyone.

Despite these dangers, bank loan Leveraged ETFs may be an easy sell to investors. Investors in fixed income instruments are compensated based upon the level of two sources of bond risk – duration risk and credit risk. Duration risk takes into account the length of time and is subject to interest rate changes. Credit risk evaluates the credit quality of the issuer. For example, U.S. Treasury’s have virtually no credit risk and investors are compensated based on the length of the bond. At the other end of the safety spectrum are low rated floating-rate debt – what bank loan Leveraged ETFs invest in. These funds are supposed to reset every 90 days in order to get exposure to the credit side but not take on much duration risk.

The Financial Industry Regulatory Authority (FINRA) has sanctioned Moloney Securities Company, Inc. (Moloney Securities) concerning allegations Moloney Securities failed to establish and maintain a supervisory system, including written policies, regarding the sale of leveraged, inverse and inverse leveraged exchange-traded funds (Non-Traditional ETFs) that was reasonably designed to meet the requirements under the securities laws.

shutterstock_172154582ETFs attempt to track a market index, sector industry, interest rate, or country. ETFs can either track the index or apply leverage in order to amplify the returns. For example, a leveraged ETF with 300% leverage attempts to return 3% for every 1% the underlying index returns. Nontraditional ETFs can also be designed to return the inverse or the opposite of the return of the benchmark. In general, Leveraged ETFs are used only for short term trading. The Securities Exchange Commission (SEC) has warned investors that most Non-Traditional ETFs reset daily and are designed to achieve their stated objectives in a single trading session. In addition to the risks of leverage, Non-Traditional ETFs held over the long term can differ drastically from the underlying index or benchmark during the same period. FINRA has also acknowledged that leveraged ETFs are complex products that carry significant risks and ”are typically not suitable for retail investors who plan to hold them for more than one trading session, particularly in volatile markets.”

FINRA found that from January 2011, through December 2012, Moloney Securities allowed its representatives to recommend and sell Non-Traditional ETFs to customers. At this time, FINRA found that Moloney’s written supervisory procedures did not address the sale or supervision of Non-Traditional ETFs. In addition, FINRA alleged that Moloney Securities did not conduct due diligence of Non-Traditional ETFs before allowing financial advisors to recommend them to customers. Despite the unique features and risk factors of Non-Traditional ETFs that FINRA has noted, FIRNA found that Moloney Securities did not provide its brokers or supervisors with any training or specific guidance as to whether and when Non-Traditional ETFs would be appropriate for their customers. FINRA also found that Moloney Securities did not use any reports or other tools to monitor the length of time that customers held open positions in Non-Traditional ETFs or track investment losses occurring due to those positions.

shutterstock_179203760The Financial Industry Regulatory Authority (FINRA) recently fined brokerage firm Investors Capital Corp. (Investors Capital) $100,000 on allegations that from at least about June 2009 through April 2011, Investors Capital failed to provide prospectuses to customers who purchased exchange traded funds (ETFs). FINRA also alleged that Investors Capital also failed to establish, maintain and enforce an adequate supervisory system concerning the sale of ETFs and the obligation to provide ETF prospectuses to customers.

Investors Capital is an independent broker-dealer offering brokerage services and financial planning to customers and has been a FINRA member since 1992. Investors Capital is headquartered in Lynnfield, Massachusetts, and employs approximately 539 registered persons, across 325 branch offices.

ETFs typically attempt to track an index such as a market index, a commodity, or an entire market segment. ETFs can be either attempt to track the index or apply leverage in order to amplify the returns of an underlying stock position. ETFs that employ leverage are called either non-traditional ETFs or leveraged ETFs. In an ideal world, a leveraged ETF with 300% leverage will return 3% if the underlying index returns 1%. Nontraditional ETFs can also be designed to return the inverse or the opposite of the return of the benchmark.

The Financial Industry Regulatory Authority (FINRA) sanctioned Edward D. Jones & Co., L.P. (Edward Jones) concerning allegations that between January 2008 and July 2009, Edward Jones failed to establish and maintain a supervisory system that were reasonably designed to ensure that the sales of leveraged and inverse exchange traded funds (Nontraditional ETFs) complied with applicable securities laws.  FINRA found that Edward Jones registered representatives recommended nontraditional ETFs to customers without first investigating those products sufficiently to understand the features and risks of the product and that consequently these recommendations were unsuitable.

Edward Jones a Missouri limited partnership and a full-service broker-dealer since 1939.  The firm’s principal offices are located in St. Louis, Missouri and the firm has more than 15,000 registered representatives and more than 10,000 branch offices throughout the United States.

As a background, Non-Traditional ETFs are usually registered unit investment trusts or open-end investment companies and are considered to be novel investment products.  While ETFs came be common place in the 1990s, the first nontraditional ETFs began trading in 2006.  By 2009, over 100 Non-Traditional ETFs existed in the market place with total assets of approximately $22 billion.  Since 2009, the number of nontraditional ETFs on the market has since increased to more than 250.

The Financial Industry Regulatory Authority (FINRA) ordered J.P. Turner & Company, L.L.C. (JP Turner) to pay $707,559 in restitution to 84 customers for sales of unsuitable leveraged and inverse exchange-traded funds (Non-Traditional ETFs) and for excessive mutual fund switches.  The current fine and is just one of several sanctions that regulators have brought against JP Turner brokers concerning the firms sales and supervisory practices.

Brad Bennett, FINRA Executive Vice President and Chief of Enforcement, was quoted in the settlement stating that “Securities firms and their registered reps must understand the complex products they are selling and the risks inherent to the products, and be able to determine if they are suitable for investors before recommending them to retail customers.”

As a background, Non-Traditional ETFs are novel products that have grown significantly in popularity since 2006.  By 2009, over 100 Non-Traditional ETFs existed in the market place with total assets of approximately $22 billion.  A leveraged ETF seeks to deliver two or three times an index or benchmark return the ETF tracks.  Non-Traditional ETFs can also be “inverse” or “short” meaning that the investment returns the opposite of the performance the index or benchmark.  While both ETFs and Non-Traditional ETFs track indexes, Non-Traditional ETFs contain significant risks that are not associated with traditional ETFs.   Non-Traditional ETFs have additional risks of daily reset, use of leverage, and compounding.

The Financial Industry Regulatory Authority (FINRA) sanctioned brokerage firm Silver Oak Securities, Inc. (Silver Oak) concerning allegations from January 2009, to December 2010, Silver Oak failed to establish and maintain a supervisory system reasonably designed to achieve compliance with applicable securities laws regarding the sale of leveraged and inverse Exchange-Traded Funds (Non-Traditional ETFs).  Silver Oak has been a FINRA member since 2007 and is in Jackson, Tennessee, and employs 122 registered individuals at 28 branch offices.

Non-Traditional ETFs have grown significantly in popularity since 2006.  By 2009, over 100 Non-Traditional ETFs had been issued with total assets under management of approximately $22 billion.  A leveraged ETF seeks to deliver two or three times an index or benchmark return the ETF tracks.  Non-Traditional ETFs can also be “inverse” or “short” returning the opposite of the performance the index or benchmark.  Non-Traditional ETFs contain significant risks that are not found in traditional ETFs.   Non-Traditional ETFs have risks associated with a daily reset, use of leverage, and compounding.

In addition, the performance of Non-Traditional ETFs over long periods of time tend to differ significantly from the performance of the underlying index or benchmark the fund tracks.  For example, between December 2008, and April 2009, the Dow Jones U.S. Oil & Gas Index gained two percent while a leveraged ETF that tracked the index’s daily return fell six percent.  Another related leveraged ETF seeking to deliver twice the inverse of the index’s daily return fell by 26 percent.  These risks, among others, prompted FINRA to issue a Notice to Members clarifying brokerage firm obligations when selling Non-Traditional ETFs to customers.

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