Efforts to keep nontraditional ETFs out of the hands of unsophisticated investors are heating up as regulators and an influential senator take aim at sales of the risky products.
Citigroup Global Markets Inc., Morgan Stanley, UBS Financial Services Inc. and Wells Fargo Advisors LLC last week agreed to pay $9.1 million to settle allegations that they sold leveraged and inverse exchange-traded funds to clients who had no business investing in the complex instruments. Clients included a 92-year-old, an 89-year-old who had 59% of his account in a nontraditional ETF and a 65-year-old with a net worth of $50,000, according to the Financial Industry Regulatory Authority Inc.
In its first actions against firms that put clients in these products, Finra said the four wirehouses experienced supervisory failures and lacked a “reasonable basis” for recommending the securities to certain clients. Together, the firms bought and sold $27 billion of the nontraditional ETFs from January 2008 through June 2009, Finra said.
The firms agreed to pay the fines of $7.3 million and restitution of $1.8 million without admitting or denying the allegations. The brokerages each said they have since changed their sales practices regarding nontraditional ETFs.
The regulatory move on Tuesday spurred Sen. Jack Reed, D-R.I., chairman of the Senate Banking Subcommittee on Securities, Insurance and Investment, to call for a second hearing about ETFs and related issues. He said the Securities and Exchange Commission is closely monitoring ETFs, “and so am I.”
“My hearing last fall shined a light on these products, which may be affecting market structure, volatility and price discovery, and have the potential to harm investors,” Mr. Reed said. “I think this market deserves more attention from both domestic and foreign regulators.”
For its part, the SEC in March 2010 stopped approving applications for ETFs that use derivatives and indicated that it wants to review whether additional investor protections are warranted, particularly for leveraged and inverse ETFs.
The commission's staff “has not completed its review,” SEC spokes-man John Nester said last week.
Leveraged and inverse ETFs carry risks above those of a traditional ETF, which that represents an interest in a portfolio of securities that track an underlying index or benchmark.
The more exotic ETFs are riskier because they reset daily and use leverage and compounding. Results of leveraged and inverse ETFs can differ significantly from the performance of the underlying index, especially when held for long periods of time and during volatile markets.
The fund industry is looking at ways to help investors understand the differences among ETFs, said Rachel McTague, a spokeswoman for the Investment Company Institute, which represents companies that sell ETFs and mutual funds.
“It is critical that investors and the general public, as well as regulators, understand different products, their risks and Finra's suitability requirements,” she said.
Direxion is one of the firms that offer leveraged and inverse ETFs.
“These products seek a daily goal,” said Andrew O'Rourke, chief marketing officer of Direxion Funds. “They are absolutely not buy-and-hold investments and should not be viewed through the same lens as a typical buy-and-hold mutual fund.”
These nontraditional ETFs are not for advisers who meet with clients two to four times a year and re-balance portfolios monthly or quarterly, Mr. O'Rourke said. They could be valuable, however, for advisers who believe in active management and seek out short-term trading opportunities with a portion of a client's portfolio, he said.
In the actions last week, Finra offered an example of the negative results of holding leveraged and inverse ETFs over a long period with volatile market conditions. It said that between Dec. 1, 2008, and April 30, 2009, the Dow Jones U.S. Oil and Gas Index gained 2%, while an ETF that sought to deliver twice the index's daily return fell 6% and the related ETF that was designed to deliver twice the inverse of the index's daily return fell 26%.
WARNING, THEN BANS
Finra and the SEC published a joint investor alert in 2009 warning that leveraged and inverse ETFs are complicated investments that focus on meeting daily performance goals. The agencies said long-term performance is likely to be very different than the investment's stated daily objectives, and recommended that investors discuss the products with an investment professional.
“As soon as the notice went out, most firms banned their retail financial advisers from selling leveraged and inverse ETFs,” said Christian Magoon, a consultant for ETF-related companies.
Since then, firms have waited to see whether regulators will require additional product disclosures, put new restrictions on investor qualification or even require some sort of certification for advisers, he said.
“The SEC obviously didn't think people would use these products incorrectly based on the prospectus language, but when the investments got into the real market, tons of people began using them incorrectly,” Mr. Magoon said.
“At this point, they haven't found anything wrong with the actual products,” he said.
The number of nontraditional ETFs has grown from a handful in June 2006, when they began trading on national securities exchanges, to more than 100 by April 2009, with total assets of about $22 billion, according to Finra.
“It's the dark side of growth for any business — products and technology growing quickly without everyone understanding them,” Mr. Magoon said.
— Mark Schoeff Jr. contributed to this story.