Finra's ETF notice angers ICI, firms

JUL 12, 2009
The Investment Company Institute and ETF firms are taking on the Financial Industry Regulatory Authority Inc., following the regulator's warning to brokers last month that that inverse and leveraged exchange traded funds “typically are unsuitable for retail investors” who hold them longer than a day. The Washington-based ICI asked Finra to withdraw its notice, writing in a June 29 letter that “such a definitive statement appears to usurp a member's ability to determine whether these products, or an investment strategy utilizing these products, are, in fact, suitable for a particular investor.” That, however, does not seem likely. In its June 11 notice, New York- and Washington-based Finra said that inverse and leveraged ETFs deliver promised returns on a daily basis, but because of compounding fail to deliver such returns over longer periods. For example, year-to-date as of July 7, the ProShares Ultra S&P 500 ETF (SSO) from ProShare Advisors LLC of Bethesda, Md., which seeks to deliver twice (200%) the daily performance of the Standard & Poor's 500 stock index, was down 8.29%, while the index itself was down 1.12%. The ProShares UltraShort S&P 500 ETF (SDS), which seeks to deliver twice (200%) the opposite of the S&P 500, was down 15.20%. And the ProShares Short S&P 500 ETF (SH), which seeks to deliver the inverse of the daily performance of the S&P 500, was down 4.94%. “Exotic ETFs, such as inverse, leveraged and inverse-leveraged ETFs, are extremely complicated and confusing products, and the marketing and sale of these products to unsophisticated retail investors is very much on Finra's radar screen,” Finra spokesman Herb Perone wrote in an e-mail. “That's why we issued this guidance to firms and brokers, reminding them of their obligations.” Finra is also conducting an information-gathering sweep of U.S. firms that sell such ETFs, seeking details about their volume of sales to retail customers, disclosure practices, sales practices, suitability analyses, advertising and marketing materials, Mr. Perone wrote.

STATING LIMITATIONS

Given the complicated nature of inverse and leveraged ETFs, Finra's actions are warranted, said Scott Kubie, the chief investment strategist at CLS Investments LLC, an Omaha, Neb.-based adviser with $3 billion under management. “I think it makes sense for Finra to state some sort of limitation on how they are used,” said Mr. Kubie, who has used such ETFs in the past. Leveraged and inverse ETFs can be damaging to an investor's bottom line, said Armond Dinverno, a financial adviser and co-president of Balasa Dinverno & Foltz LLC of Itasca, Ill., which manages more than $1 billion in assets. “It appears Finra is trying to act in the best interest of investors,” he said. That may be Finra's intent, but saying that leveraged and inverse ETFs are unsuitable for investors who plan to hold them longer than a day is false, said Michael Sapir, chairman and chief executive of ProShare, the largest provider of such ETFs. “You can use them for more than a day successfully,” he said. The key is to monitor performance, and if a leveraged or inverse ETF deviates from its benchmark by more than is desired, “what you should do is buy or sell shares to bring it back in line,” Mr. Sapir said. ProShare is starting a campaign to demystify leveraged and inverse ETFs in face-to-face conversations with brokers and advisers. “We're trying to be proactive, trying to give some information to brokers and advisers, because the Finra notice has raised issues,” Mr. Sapir said. Direxion Funds of Newton, Mass., is also reaching out to brokers and advisers to argue that the funds can be used successfully, said Andy O'Rourke, the firm's marketing director. “It's entirely true that the funds have daily investment objectives and people should understand what that means,” he said. “But it doesn't mean that you should only hold them for a day or less.” Rydex SGI of Rockville, Md., takes the position that leveraged and inverse ETFs can be held longer than a day if the funds are monitored properly, said Carl Resnick, the firm's ETF portfolio strategist. Together, the three firms are the primary providers of leveraged and inverse ETFs, a lucrative niche. Year-to-date through June 30, total ETF assets at ProShare increased $6.89 billion, or 33.6%, to $27.38 billion; assets at Direxion increased $4.13 billion, or an astounding 442.1%,to $5.07 billion; and assets at Rydex SGI increased $492 million, or 11.6%, to $4.73 billion, according to State Street Global Advisors of Boston. All three firms have filed to offer future inverse and leveraged ETFs.

TROUBLING TREND?

The increased focus on the niche is a troubling trend, said Paul Justice, an ETF analyst at Morningstar Inc. of Chicago. Although it is true that re-balancing frequently can lead leveraged and inverse ETFs to generate long-term returns in line with their daily targets, that can be expensive and time-consuming for the average investor, he said. And while the firms that produce these ETFs claim that they're not marketing the funds to retail investors, the evidence suggests that at least some of the money flowing into the funds is from such investors, Mr. Justice said. “Hundreds” of e-mails from investors who have been burned by leveraged and inverse funds have found their way into his inbox, he said. Such investors need protection, and Finra's actions should help provide it, Mr. Justice said.
There is no doubt that leveraged and inverse ETFs can be dangerous, said Harold Evensky, president of Evensky & Katz Wealth Management, a Coral Gables, Fla., firm with $500 million under advisement. Despite his reservations, however, he said that he is reluctantly siding with the ICI. “It makes me nervous when a regulator starts telling us how to use specific products,” Mr. Evensky said. “It doesn't strike me as a reasonable role for [Finra] to step into.” E-mail David Hoffman at [email protected].

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