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  • Jordan Green, Esq.

Increased SEC Scrutiny on Exchange Traded Products

Part 1: Inverse & Leveraged ETF’s


Last week the Securities and Exchange Commission announced that it had reached settlement with multiple RIAs in connection with their recommendations of certain exchange traded products. The products in question were certain VIX-related securities; however the concerns raised by the SEC are directly applicable to all leveraged and inverse ETFs. Each firm involved in the recent settlements was required to pay a minimum of $500,000 in monetary penalties. All advisers who currently recommend, or plan to recommend in the future that clients purchase such securities should take this recent action very seriously. While this is not the first time that the SEC has penalized firms for their use of Exchange Traded Products, the increased initiative to identify such trading serves as a warning that further scrutiny is not just possible, but guaranteed.

The SEC, in announcing the recent penalties, stressed that “It is critically important for registered investment advisers and broker-dealers to implement robust and effective policies and procedures reasonably designed to prevent violations of the federal securities laws, which includes ensuring that their financial professionals understand the risks and purposes of the products they advise on and/or recommend to firm clients and customers…Moreover, firms must ensure that their financial professionals, including independent contractors acting on their behalf, actually follow in practice those firm policies and procedures.”[1] Among the SEC’s many concerns included the failure of advisers to monitor these products and the enhanced losses realized by clients when advisers were not expeditious in their trading in and out of products meant to be held for short periods of time.

Like securities tied to volatility, leveraged and inverse ETFs have significant risks. One of the key risks associated with such ETFs is the mathematical compounding inherent to them. Most leveraged and inverse ETFs “reset” daily because they are designed to achieve their stated objectives on a daily basis. Due to the effect of compounding, their performance over longer periods of time can differ significantly from the performance (or inverse of the performance) of their underlying index/benchmark during the same period of time. It is important to understand this concept of compounding and the risk associated with it. If you do not understand this, you should not invest client money in these products. To do so would be gambling…blindfolded.

The first rule of fight club is that you do not talk about fight club.

The first rule of being a RIA is that you do not gamble with client money.

Leverage can increase volatility. The longer you hold a leveraged or inverse ETF, the greater the potential for loss. As such, these products may not be suitable for investors who plan to hold positions for longer than one trading session, particularly in volatile markets. Like traditional ETFs, some leveraged and inverse ETFs track broad indices, some are sector-specific and others are linked to commodities or currencies, which historically have been highly volatile. Yes, this includes Bitcoin/$GBTC. More on this in a future post.

Additionally, the expense ratios of leveraged and inverse ETFs are typically higher than traditional ETF products, which will increase costs and may add to any negative effects from compounding. It’s important that advisers read the prospectuses carefully before making an investment decision. After that decision is made, the investment must be closely monitored to avoid what could become a catastrophic loss.

The SEC has previously warned investors and investment advisers to use caution when analyzing these products, including an Investor Alert titled “Leveraged and Inverse ETFs: Specialized Products with Extra Risks for Buy-and-Hold Investors.” You are encouraged to review this alert in order to more fully understand the risks associated with these products, a copy of this SEC alert may also be viewed here.

With this in mind, it is absolutely vital that RIAs conduct a self-assessment of their trading activities and identify whether or not they have been involved in the trading of these products. Advisers who do in fact use inverse or leveraged ETFs should consider immediately implementing the following policies and procedures:

1. Developing suitability guidelines to determine which clients can tolerate the enhanced risk of certain leveraged/inverse products. This is absolutely necessary before trading any of these securities. In fact, the SEC has proposed a rule that would make it illegal to trade these products without ensuring clients understand the accompanying risks.

2. Creating and abiding by a procedure to ensure that staff obtain written consent from clients that they understand the risk of such products and grant advisers the discretionary authority to include them in portfolios.

3. Conducting training for staff regarding the risks, suitability, and trading strategy that must be considered with the use of such products.

4. Creating a policy requiring the necessary supervision of such products. The SEC specifically identified that many of these products are designed to be held for extremely short periods of time. Accordingly, if you do not have the resources to monitor these securities on a daily, if not hourly basis, then you have no business placing them in client accounts.

5. Ensuring adequate disclosures are made on the Form ADV Part 2A and Form CRS regarding the use of these products, their roles in portfolio construction, and the inherent risks they carry.

Team Swayze recommends that if you have not already discussed this issue with your compliance consultant and have not implemented the above recommendations, you contact us immediately to ensure that the proper steps are taken to protect your clients from potential harm and your RIA from serious monetary fines.


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