In July 2019, the North American Securities Administrators Association (“NASAA”) issued a report that provided a warning as to the risks of leveraged and/or inverse exchange-traded funds. The report urges broker-dealers to tailor their supervisory procedures if they allow ETF transactions in these products.
The report is based in part on information that was collected through an inquiry sent to broker-dealers, which was designed to obtain a better understanding of whether broker-dealers are recommending these products, and how these broker-dealers are supervising these transactions. This inquiry resulted in 118 responses. Of the responding firms, 86 (73%) allowed leveraged and/or inverse ETFs to be held in retail customer accounts. With respect to these 86 firms:
- 52% permitted representatives to recommend leveraged and/or inverse ETFs to their customers; and
- 83% of the firms allowing leveraged and/or inverse ETFs in customer accounts confirmed that they have policies and procedures to address ETFs that are leveraged and/or inverse.
However, the report noted that only 59% of the respondents address the review of customer suitability and only 26% generate an exception report for positions held longer than one trading session. These responses resulted in a recommendation that firms review and update their supervisory procedures as they apply to these products.
The full text of the report, including its additional analysis of the practices of other broker-dealer responses, may be found at the following link: https://s30730.pcdn.co/wpcontent/uploads/2019/07/2019-BD-Study-ofExchange-Traded-Funds-FINAL.pdf.
The report concludes with recommendations for broker-dealers who offer these products. In particular, they should consider:
- establishing customer eligibility (suitability) criteria for these purchases;
- providing customers with educational materials regarding the risks of leveraged and/or inverse ETFs prior to the first sale;
- requiring mandatory training and a formal approval process prior to permitting representatives to recommend a leveraged and/or inverse ETF;
- reviewing recommendations of leveraged and/or inverse ETFs based on a customer’s investment objective, risk tolerance, age, and financial profile;
- imposing holding period time frames to prompt a supervisory review when leveraged and/or inverse ETFs are held longer than the appropriate period; and
- creating trade reports, exception reports, and alerts designed to attract supervisory attention when leveraged and/or inverse ETFs are held for longer than the recommended period, and/or are held by customers who do not meet specific suitability criteria.
The report also concludes that broker-dealers should carefully consider whether to permit purchases of leveraged and/or inverse ETFs in retail customer accounts. If permitting transactions in leveraged and/or inverse ETFs, a firm’s supervisory procedures should be sufficiently tailored to address the risks associated with these products.
Of course, many of the conclusions of the report are appropriate to consider in connection with sales of other leveraged and inverse products, including exchange-traded notes, which typically raise comparable considerations.