Mass. blasts RBC for ETF sales

Addressing an issue that many thought had been resolved several years ago, Massachusetts last week filed an administrative complaint against RBC Capital Markets LLC and one of its former brokers, Michael Zukowski, for “dishonest practices in selling leveraged and inverse leveraged ETFs.”

The suit alleges that neither he nor many of his clients understood the products and the risks involved with them.

“If the individual recommending the products didn’t understand them, how could his clients?” said Secretary of State William Galvin, who heads securities regulation in Massachusetts.

“These products might be appropriate for sophisticated investors, but not for many of the people we’ve had complaints from. The firm understood this but didn’t adequately educate their agents,” Mr. Galvin said.

The investigation continues, and there “could be more firms and agents involved,” he said.

Mr. Galvin is seeking a cease-and-desist order, an administrative fine and restitution for Massachusetts investors who suffered losses in the funds.

The charges from his office are related to transactions that occurred between early 2007 and December 2009, after which RBC halted most sales of the funds to retail clients.

Mr. Zukowski left the firm last December and now works for independent broker-dealer Wall Street Financial Group Inc. He wasn’t available for comment.

Most broker-dealers, including RBC, put the brakes on the sale of leveraged and inverse leveraged exchange-traded funds a couple of years ago after the Securities and Exchange Commission and the Financial Industry Regulatory Authority Inc. issued warnings about the controversial products. But some firms may still face regulatory action from past sales practices.

In a written statement, RBC said that it now has appropriate procedures in place regarding the sale of the funds.

“We are disappointed that [Mr. Galvin] decided to take this step … We have in place extensive policies and procedures and training requirements, and believe we are in compliance with regulatory requirements and with industry best practices in this arena.”

Leveraged and inverse ETFs seek to deliver multiples of positive or negative price moves in stock indexes, bonds, commodities and other asset classes. The problem is that they are structured to meet their investing objectives on a daily basis.

The portfolios typically use swaps and other derivatives contracts to mirror the price moves in underlying assets, and most re- balance at the end of each trading day to maintain the desired exposure. Because of the leverage involved, downward moves in a market are hard to recover from.

The result is that longer-term returns on these products can vary widely from the underlying asset, particularly in volatile markets.

“The downs hurt much more than the ups, and zigzagging markets can really erode the principal,” said Scott Burns, director of ETF analysis at Morningstar Inc. “They’re suitable [only] for active traders who watch their portfolios every day.”

The problem is not with the product but with the purveyors of it, said Dave Nadig, director of research at IndexUniverse LLC.

‘READ THE MATERIAL’

“Most leveraged and inverse ETFs do what they say they’ll do. If you want a three-day hedge, this is the product you want,” Mr. Nadig said.

“But a continuing problem of the industry is to get advisers and investors to read the material they put out,” he said.

The regulators have given fair warning. Both Finra and the SEC issued advisories about leveraged ETFs in the middle of 2009, and the SEC still has not lifted a moratorium on registration of new ETFs using derivatives which it put into effect in April of last year, though it doesn’t apply to existing producers.

Late last month, the North American Securities Administrators Association Inc. gave an additional warning on leveraged ETFs.

“Check under the hood,” NASAA president David Massey said. “[Investors] should understand the risks, costs and tax consequences before investing in ETFs.”

All the warnings have slowed down demand somewhat for the juiced products.

When ProShares, which is battling class actions related to its products, issued the first leveraged ETF in 2006, the market took off. But according to Morningstar data, the growth has slowed recently.

There are 229 leveraged and/or inverse ETFs in the market with $36.3 billion in assets. That compares with 140 funds managing $30.6 billion in assets at the end of 2009.

Another reason for the slowdown is that brokerage firms, including RBC Capital Markets, Ameriprise Financial Inc., Edward Jones, LPL Financial LLC, Morgan Stanley Smith Barney LLC and UBS Financial Services Inc. temporarily suspended sales of the ETFs to retail clients in 2009 and increased the oversight of their use by advisers and clients.

CONTINUED COMPLAINTS

Jackie Knolhoff, a spokeswoman for Edward Jones, said that the firm hasn’t resumed sales of leveraged ETFs.

The other firms declined to comment.

The SEC, however, continues to receive complaints about leveraged ETFs, said Lori Schock, director of its Office of Investor Education and Advocacy.

“This is a viable product, but people need to know what they’re getting into,” she said. “If you have a buy-and-hold strategy with these products, you can get in big trouble really fast.”

And if an adviser doesn’t understand the product and spell it out in detail to customers, they too could be in hot water.

Although Finra wasn’t able to break out the number of investor arbitration claims involving leveraged and inverse ETFs, the number of claims related to ETFs overall has grown substantially, from 28 in 2009 to 112 last year. Sixty-one claims have been filed year-to-date, a pace that is on par with last year’s.

Mr. Galvin is known as one of the more aggressive state securities regulators, but given what experts said were looser sales practices when the funds were introduced, charges against other broker-dealers could still be in the works.

Email Andrew Osterland at [email protected]

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