Monthly Archives: September 2009

The controversy surrounding leveraged exchange traded funds (ETFs) shows no sign of letting up, and on Sept. 1, the Financial Industry Regulatory Authority (FINRA) announced plans to raise margin requirements for leveraged ETFs beginning Dec 1. FINRA’s Regulatory Notice 09-53 states that the “inherent volatility” of leveraged ETFs is one of the reasons for the new requirements.

The change in regulations comes on the heels of a lawsuit filed by a group of investors in August against ProShares and one of its leveraged inverse ETFs. The investors allege that ProShares misrepresented the UltraShort Financials ProShares Fund and that they were never informed shares in the fund should not be held for more than one single trading day.

Leveraged ETFs are considered a subset of traditional ETFs and attempt to generate multiples (i.e. 200%, 300% or greater) of the performance of the underlying index or benchmark they track. Some leveraged ETFs are “inverse” funds, which means they try to deliver the opposite of the performance of the index or benchmark they track. Leveraged ETFs can include among their holdings high-risk derivative instruments such as options, futures or swaps.

The complexity and potential risks associated with leveraged ETFs have garnered both the media spotlight and the attention of regulators who contend many retail investors do not fully understand how the products work. Both FINRA and the Securities and Exchange Commission (SEC) recently issued warnings highlighting the risks for investors in leveraged ETFs, particularly those who invest for the long term. In response, some brokerage firms announced new sales limits on client investments in leveraged ETFs, while others halted sales altogether.

In July, Massachusetts’ Secretary of State William Galvin launched an inquiry into how three leveraged ETF providers – Rydex, ProShares and Direxion – marketed and sold leveraged ETFs, as well as what they were telling brokers who sold the funds to clients. Detractors of leveraged ETFs, including FINRA and the Securities and Exchange Commission (SEC), contend retail investors may not fully understand the complexity of ETFs nor realize the products must be monitored on a daily or near daily basis.

Three years ago, there were no leveraged ETFs in existence. Today, there are more than 140 leveraged ETFs with about $30 billion in assets.

As expected, H. David Kotz, Inspector General of the Securities and Exchange Commission (SEC), has delivered a scathing report on the agency’s mishandling of the Bernie Madoff scandal. The much-anticipated report is 450 pages in length, and blasts the SEC for never conducting “a thorough and competent investigation or examination” of Madoff and his investment advisory businesses. The inspector general goes on to reveal how the agency’s “inexperienced” attorneys remained oblivious to Madoff’s $65 billion Ponzi scam, accepting Madoff’s answers to their questions even when the responses were “seemingly implausible.”

The report also notes that during the course of several examinations by SEC staff members into Madoff, the financier made overt efforts to “impress and even intimidate the junior examiners from the SEC.” According to the report, Madoff emphasized his role in the securities industry, emphasizing his ties with high-ranking members at the agency. One of the examiners characterized Madoff as “a wonderful storyteller” and “very captivating speaker” and noted that he had “an incredible background of knowledge in the industry.”

Read the executive summary of the report here.

In March, Madoff was sentenced to 150 years in a North Carolina federal prison for his role in masterminding what is considered the biggest Ponzi scheme in history. Investors, including ordinary citizens, hedge funds, charities, famous names in the entertainment world and others, lost more than $65 billion to Madoff’s scheme.

These are scary times for investors. Stories of stockbroker negligence, record Ponzi schemes, investment fraud, and client misrepresentation have become an everyday occurrence. It’s no wonder investors – seasoned pros and novices alike – are increasingly wary when it comes to seeking advice from an investment advisor or financial representative, questioning if anyone associated with Wall Street can be trusted nowadays. I’m reminded of a scene from the 1976 film Network in which fictitious newsman Howard Beale (played by the late actor Peter Finch) delivers his “mad as hell and I’m not going to take this anymore” speech.

Jo L. Wright no doubt felt the way of Finch’s character. Wright, a church secretary from Whitestown, Indiana, lost thousands of dollars in a bond fund formerly managed by Morgan Keegan & Company. Wright’s initial introduction to the Memphis-based brokerage was through her local Indiana Regions bank branch manager. At the time of the referral, Wright had her money in what she deemed “safe” and “secure” investments: a certificate of deposit and a savings account.

That all changed based on the recommendation of the bank manager and Morgan Keegan. Wright transferred her money into the Morgan Keegan Select Intermediate Bond Fund. Relying on the information provided by Morgan Keegan and her Regions Bank manager, she believed the fund was a safe, conservative investment and that any risk of principal loss was virtually non-existent.

In truth, Wright actually put her money into a high-risk and speculative financial product, one with significant ties to complex structured finance investments that included subprime mortgage securities. In no way was it the kind of investment that a conservative-minded investor like Wright should have been advised to purchase.

Wright didn’t know that, however, because her financial advisor allegedly didn’t tell her. Nor did Wright receive a prospectus about her investment before purchase.

Wright eventually filed a complaint against Morgan Keegan with the Financial Industry Regulatory Authority (FINRA), and in March 2009 was awarded $18,000 for the financial losses she suffered. Her case underscores several important issues, however, when it comes to investing your money and selecting a financial advisor.

First, it’s your money. That means investors need to do some due diligence of their own. This includes asking your financial advisor some tough questions. Chief among them: Where has your advisor worked in the past? Is there a pattern of multiple jobs in a short period of time? If the answer is yes, it could be a red flag.

Another key question concerns compensation. How is the financial advisor paid for his or her services? Is it based on an hourly rate, flat fee, or commission? In addition, find out if the advisor is given bonuses for selling certain investment products. If so, this clearly could be a conflict of interest if one of those products is pushed to become part of your investment portfolio.