DENVER, CO – May 10, 2023 - The Colorado Division of Securities’ (“Division”) is issuing this Adviser Alert to bring attention to the risks of inverse and leveraged ETFs and the short-term and volatile nature of these complex products.
The Division continues to see client losses related to adviser recommendations that do not reflect an understanding of the underlying products, the risks of holding these ETFs for more than a day, and the unsuitability of these risks to clients.
It is imperative that advisers are aware that these products are meant to be held for no more than a single day. Fiduciaries must diligently monitor, assess and document how any placements longer than a day are in a client’s best interest.
The SEC has recently taken action (In the Matter of Classic Asset Management, LLC,) against a firm and part owner in connection with long term holdings of leveraged ETFs. The Division has also taken enforcement actions in connection with unsuitable recommendations of Inverse and leveraged ETFs in the following actions:
- In the Matter of Legacy Financial, LTD and Derek Serlet, Consent Order, 2023-CDS-007;
- Chan v. Virginia Himmelsteib King and V.H. King Associates, case number 2020CV33909, (District Court, Denver County, Colorado, 2020);
- In the Matter of Pathway Advisors Group and William D. Frier, Consent Order, 2019-CDS-045;
- In the Matter of Qualitas Wealth Counsel, LLC and James McMillan, Consent Order, no. 15-L-03; and
- In the Matter of Jeff M. Wilson and Wilson Advisory Group, LLC, case number 13-XY-002.
Inverse and leveraged ETFs are complex investment products, the risks of which are not properly understood by non-institutional investors. Some ETFs are designed to perform as if the investor is using borrowed funds (known as “leveraged ETFs”). These ETFs can deliver multiples of the daily performance of the index or benchmark that it tracks. Most leveraged ETFs reset each day, which means they are designed to achieve their stated objective on a daily basis.
Escalating risks and volatility:
One of the risks associated with leveraged ETFs is the compounding over time of the daily returns that ETFs are designed to achieve (“compounding risk”), which can create unpredictable returns even when they successfully achieve their stated daily objective day after day. When held for periods longer than one day, volatility present in the index the leveraged ETF tracks skews the overall returns when the index or sector moves in the general direction the purchaser predicted or expected. Essentially, the ETF becomes “detached” from its benchmark. The greater the volatility in the market, the more likely the leveraged ETF will produce an extreme or unpredictable result.
Short-term, single-day investments:
According to FINRA Regulatory Notice 09-31 (issued in June of 2009), inverse and/or leveraged ETFs that reset daily typically are unsuitable for retail investors who plan to hold them for longer than one trading session. A single day is also the typical recommended holding period in these products’ prospectuses.
Best practice recommendations:
Advisers must understand all products that they recommend including complex ones like inverse or leveraged ETFs. These products are meant to be held for a single day or less. If an adviser is recommending the purchase or holding for a period longer than one day, it is imperative that the adviser does so only in the best interest of the client. Advisers should consider the following:
- Review the product prospectus and understand how the specific product works and how it fits into your investment strategy. If using a product inconsistent with its stated purpose, exercise due care in monitoring and disclose the associated risks to clients, including that the adviser is not trading the products according to the purpose for which they were designed.
- A product with unpredictable returns, regardless of the size of the holding in clients’ accounts, is generally not appropriate for most investors because of its speculative nature. An unpredictable inverse or leveraged ETF does not support a “hedge” or “over allocation” strategy, respectively. Consider other investment options to achieve the desired strategy. If recommending these products to certain clients, carefully document the suitability of these products for client accounts based on the products and the clients’ risk profiles.
- If held for longer than a single day, the adviser must be able to show grounds that the advice is in the client’s best interest. You should be monitoring the position and continuously assessing how the risk and volatility is meeting the best interests of the client and you should be documenting the work.
- Monitoring of long held positions should include reviewing the ETFs’ performance against the underlying benchmark over different time periods, not just day to day, and the data monitored should be documented to be readily available to the Division during an examination or document request.
- Disclose in the Firm Brochure under Item 8 how the product fits into your investment strategy as well as the describe the significant risk of holding such product long term in significant detail.
This alert along with other investment adviser compliance resources can be found on the Division’s website at IA Guides and Resources.
If you have any questions or need to contact the Division, our phone number is 303-894-2320 or you can email us at dora_SecuritiesWebsite@