Monthly Archives: May 2012

Inverse and leveraged exchange-traded funds (ETFs), which have faced ongoing scrutiny by regulators in recent months, are now garnering the attention of lawmakers on Capitol Hill.

As reported May 3 by Investment News, Sen. Jack Reed, D-R.I., chairman of the Senate Banking Subcommittee on Securities, Insurance and Investment, announced that he is continuing to monitor the complex financial products and plans to follow up on a hearing he held last year with another one in the near future.

Earlier this week, leveraged and inverse ETFs took center stage when the Financial Industry Regulatory Authority (FINRA) levied $9.1 million in penalties on four major banks – Citigroup Global Markets, Morgan Stanley & Co., UBS Financial Services and Wells Fargo Advisors – for their role in selling the risky investments to retail clients who, because of their conservative risk profiles, should never have purchased them.

According to FINRA, the brokerages failed to adequately educate their own representatives about the complexities – and inherent risks – of leveraged and inverse ETFs. The same representatives then marketed and sold the products to investors who were uneducated about the potential dangers that inverse and leveraged ETFs hold.

Exchange-traded funds are essentially baskets of investments – stocks, bonds, commodities, currencies and options – that track market indexes. In recent years, however, traditional ETFs have grown increasingly complex, delving into esoteric and risky areas that involve swaps, futures contracts and other derivative instruments.

Leveraged and inverse ETFs are two of the most risky ETFs. Leveraged ETFs are designed to deliver “multiples” on the performance of the index or benchmark they track. Its cousin, the inverse ETF, works in the reverse way by trying to deliver returns that are opposite of an index’s returns.

The problem that many investors make with leveraged and inverse ETFs is that they hold these investments for longer than one single trading day. Leveraged and inverse ETFs are not designed for long-term returns. Rather, their goal is to try and achieve their stated performance objectives on a daily basis. Holding a leveraged or inverse ETF for a longer period of time may result in a financial nightmare.

Several of the nation’s leading banks – including Citigroup, Morgan Stanley, UBS and Wells Fargo – were recently sanctioned by the Financial Industry Regulatory Authority (FINRA) for more than $9.1 million over their failure to supervise retail sales of leveraged and inverse exchange-traded funds (ETFs). In addition to supervisory failures, FINRA said the banks failed to have “a reasonable basis” for recommending the products to investors in the first place.

“The added complexity of leveraged and inverse exchange-traded products makes it essential that brokerage firms have an adequate understanding of the products and sufficiently train their sales force before the products are offered to retail customers,” said J. Bradley Bennett, FINRA enforcement chief, in a statement.

“Firms must conduct reasonable due diligence and ensure that their representatives have an understanding of these products,” he added.

 The break-down of the fines is as follows: 

• Wells Fargo – $2.1 million fine and $641,489 in restitution;
• Citigroup – $2 million fine and $146,431 in restitution;
• Morgan Stanley – $1.75 million fine and $604,584 in restitution; and
• UBS – $1.5 million fine and $431,488 in restitution.

Both the Securities and Exchange Commission (SEC), the North American Securities Administrators Association and FINRA have issued separate and joint warnings to investors about leveraged and inverse exchange-traded funds in recent months. Specifically, regulators are concerned about the increasing complexity of the products, their lack of transparency and their potential to cause significant financial losses to investors who do not thoroughly understand how inverse and leveraged funds actually work.

Leveraged ETFs seek to deliver “multiples” of the performance of the index or benchmark they track. Inverse ETFs do the reverse. They try to deliver the opposite of the performance of the index or benchmark being tracked.

The past year has been a rocky roller coaster ride for many broker/dealers, as the fallout from soured private-placement deals in Medical Capital Holdings, Provident Royalties and DBSI Inc. caused more than 50 broker/dealers that sold those products to close up shop.

According to findings in a new report by the Compliance Department consulting group, 93 broker/dealers closed their doors during the first three months of 2012, while 137 B-Ds shut down in the first quarter of 2011. Meanwhile, fewer new B-Ds are opening.  Forty-four new broker/dealers opened in the first quarter of 2012, compared to 57 for the same time period in 2011.

As reported May 1 by Investment News, the Financial Industry Regulatory Authority (FINRA) shows 4,428 broker/dealers were open in March, compared to 5,005 in 2007. That’s an 11% decline over five years.

Many of the problems facing broker/dealers are the result of legal and regulatory issues over private-placement investments involving Medical Capital Holdings and Provident Royalties, as well as tenant-in-common exchanges manufactured by DBSI.

In July 2009, the Securities and Exchange Commission (SEC) charged both Medical Capital and Provident Royalties with fraud. On Nov. 8, 2010, DBSI filed for bankruptcy. Since then, many investors have filed arbitration claims with FINRA against the broker/dealers that sold them the failed products.

More recently, sales of private placements were responsible for the shuttering of broker/dealer Cambridge Legacy Securities LLC. On April 13, after losing a $1.5 million arbitration claim in March, Cambridge Legacy Securities filed its withdrawal request with FINRA.  A few days later, the firm sought bankruptcy protection.