In June 2009, FINRA issued Regulatory Notice 09-31 to remind firms of their sales practice obligations relating to leveraged and inverse exchange-traded funds (ETFs). At the same time, the Investment Industry Regulatory Organization of Canada (IIROC) issued guidance to the Canadian industry that is substantially similar to our Notice. In July we released a compliance podcast concerning the Notice and some of the issues that it raised. On August 18, 2009, the Securities and Exchange Commission and FINRA issued an Investor Alert to address concerns that investors—particularly buy-and-hold investors—may not understand the performance objectives and risks of these non-traditional ETFs. State regulators also have expressed concerns about the manner in which these funds are sold to investors.
Given the attention that this issue has generated, FINRA is publishing the following frequently asked questions concerning leveraged and inverse ETFs.
Q. What are leveraged or inverse ETFs?
A. The shares of an ETF commonly represent an interest in a portfolio of securities that track an underlying benchmark or index. A leveraged ETF generally seeks to deliver multiples of the daily performance of the index or benchmark that it tracks. An inverse ETF generally seeks to deliver the opposite of the daily performance of the index or benchmark that it tracks. Inverse ETFs often are marketed as a way for investors to profit from, or at least hedge their exposure to, downward-moving markets. Some ETFs are both inverse and leveraged, meaning that they seek a return that is a multiple of the inverse performance of the underlying index. To accomplish their objectives, leveraged and inverse ETFs use a range of investment strategies, including swaps, futures contracts and other derivative instruments.
Q. How can the "reset" feature of a leveraged or inverse ETF affect suitability?
A. Most leveraged and inverse ETFs reset each day, which means they are designed to achieve their stated objective on a daily basis. With the effects of compounding, over longer timeframes the results can differ significantly from their objective. Please see Regulatory Notice 09-31 and the SEC/FINRA Investor Alert for illustrations of how these discrepancies can occur.
Because they reset each day, leveraged and inverse ETFs typically are inappropriate as an intermediate or long-term investment. They may be appropriate, however, if recommended as part of a sophisticated trading or hedging strategy that will be closely monitored by a financial professional. At times, these strategies might justify a decision to hold a leveraged or inverse ETF longer than one day. However, a registered representative must carefully address the question of how to engage in these strategies in a manner consistent with the suitability rule.
Q. What does the suitability analysis require?
A. NASD Rule 2310 (Recommendations to Customers) requires that, before recommending the purchase, sale or exchange of a security, a firm must have a reasonable basis for believing that the transaction is suitable for the customer to whom it is recommended. This is a two-step determination. First, the firm must determine if the product is suitable for any customer. To do this, a firm and its associated persons must fully understand the products and transactions that it recommends. This requires an understanding of all terms and features. In the case of a leveraged or inverse ETF, these questions include consideration of how the fund is designed to perform, how it achieves that objective, the impact on performance from market volatility, the use of leverage and the appropriate holding period.
Once a product is determined to be generally suitable for at least some investors, a customer suitability analysis must be performed. With it, a firm must determine if the product is suitable for a specific customer that it may be recommended to. This analysis includes making reasonable efforts to get information on the customer's financial and tax status, investment objectives and other information deemed reasonable to make the determination.
Q. Can leveraged and inverse ETFs be suitable for a retail investor?
A. While it is not FINRA's position that all leveraged and inverse ETFs are unsuitable for all retail customers, firms that recommend them must carefully consider their suitability for each customer. Of particular concern, in light of their reset feature, is whether one is recommended as an intermediate or long-term investment rather than as part of a closely monitored trading or hedging strategy.
Q. What should firms do as new types of complex or non-traditional ETFs are introduced to the market?
A. NASD IM-2310-2(e) (Fair Dealing with Customers with Regard to Derivative Products or New Financial Products) states that "[a]s new products are introduced from time to time, it is important that members make every effort to familiarize themselves with each customer's financial situation, trading experience, and ability to meet the risks involved with such products and to make every effort to make customers aware of the pertinent information regarding the products." Firms recommending or selling new ETFs may also find it helpful to refer to Notice to Members 05-26, which highlights best practices for vetting new products.
Q. What about leveraged or inverse mutual funds?
A. Some mutual funds are leveraged or inverse—that is, they are designed to deliver multiples or the inverse of the performance of the index or the benchmark that they track. Funds such as these that are reset daily may present many of the same issues as leveraged and inverse ETFs, and should be subjected to a similar analysis.
