Inverse ETFs

FINRA Alleges Royal Securities Company Had Numerous Supervisory Deficiencies – Part I

March 4, 2014 | by Staff Attorney

The Financial Industry Regulatory Authority (FINRA) sanctioned brokerage firm Royal Securities Company (Royal Securities) concerning allegations Royal lacked adequate supervision and controls in several areas. FINRA alleged that Royal Securities failed to properly supervise two of its registered representatives, one of which utilized a unitary investment strategy for virtually all of his customers. FIRNA also found that other representative made unsuitable recommendations in three customer accounts.

FINRA alleged that between January 2010 and May 2012, representatives of Royal Securities recommended nontraditional exchange-traded funds (Non-Traditional ETFs) to customers without having a reasonable basis to do so. Further, FINRA found that Royal Securities failed to establish and maintain a supervisory system and training regarding the sale of Non-Traditional ETFs that was reasonably designed to comply with FINRA rules.

Royal Securities has been a FINRA member since September 1982 and the firm’s business lines include hedge funds, an investment advisory business, and a traditional brokerage business. Royal Securities has approximately 41 registered persons operating out of nine offices.

PNC Investments Fined by FINRA Over Sale of Non-Traditional ETFs

February 24, 2014 | by Staff Attorney

The Financial Industry Regulatory Authority (FINRA) sanctioned brokerage firm PNC Investments LLC, (PNC) concerning allegations from January 2008, through June 2009, PNC failed to establish a supervisory system, including written procedures, reasonably designed to achieve compliance with the FINRA rules in connection with the sale of leveraged, inverse, and inverse leveraged Exchange-Traded Funds (Non-Traditional ETFs).

Non-Traditional ETFs have grown in popularity since 2006. By April 2009, over 100 Non-Traditional ETFs had been issued with total assets of approximately $22 billion. Leveraged ETFs seek to deliver multiples an index or benchmark the ETF tracks. Some Non-Traditional ETFs are “inverse” or “short” funds that return the opposite of the performance the index or benchmark. ETFs can also be both inverse and leveraged and return a multiple of the inverse performance of a index or benchmark. Non-Traditional ETFs contain significant risks that are not found in traditional ETFs. Non-Traditional ETFs have risks associated with a daily reset, use of leverage, and compounding.

In addition, the performance of Non-Traditional ETFs over long periods of time can differ significantly from the performance of the underlying index or benchmark it tracks. For example, between December 2008, and April 2009, the Dow Jones U.S. Oil & Gas Index gained two percent while a leveraged ETF seeking to deliver twice the index’s daily return fell six percent. In addition, a related ETF seeking to deliver twice the inverse of the index’s daily return fell by 26 percent over the same period. These risks prompted FINRA to issue a Notice to Members clarifying brokerage firm obligations when selling Non-Traditional ETFs to customers.

Stifel, Nicolaus & Company and Century Securities Associates Fined by Regulator Over Leveraged ETFs

February 12, 2014 | by Staff Attorney

The Financial Industry Regulatory Authority (FINRA) ordered brokerage firms Stifel, Nicolaus & Company, Incorporated (Stifel Nicolaus) and Century Securities Associates, Inc. (Century Securities) to pay combined fines of $550,000 and nearly $475,000 in restitution to 65 customers concerning allegations of the improper sale of leveraged and inverse exchange-traded funds (ETFs). Stifel Nicolaus and Century Securities are affiliates and are both owned by Stifel Financial Corporation.

A leveraged ETF employs debt or leverage in order to increase and magnify the returns of the underlying securities. Leveraged ETFs are generally available for most investment indexes such as the S&P 500, the Dow Jones, commodities, or foreign exchanges. Many leveraged ETFs carry leverage as high as 300% leverage and will typically return 3% if the underlying index returns 1%. Leveraged ETFs can also be designed to return the inverse or opposite of the benchmark.

Leveraged ETFs are generally used and are only appropriate for short term trading. The Securities Exchange Commission (SEC) has warned that most leveraged ETFs reset daily, meaning that they are designed to achieve their stated objectives on a daily basis. As a result, the performance of nontraditional ETFs held over the long term can differ significantly from the performance of their underlying index or benchmark during the same period. Thus, even if an index is relatively flat over a period of time, a leveraged ETF may still decline in value during the same period.

Saxony Securities Fined by Securities Regulator Over Sale of Nontraditional ETFs

January 3, 2014 | by Staff Attorney

Broker-dealer Saxony Securities, Inc. (“Saxony”) was recently fined $15,000 over allegations by The Financial Industry Regulatory Authority (FINRA), the regulator of securities broker-dealers, that Saxony failed to establish and maintain a supervisory system, including written procedures, regarding the sale of leveraged or inverse exchange-traded ETFs that was reasonably designed to achieve compliance with the FINRA rules.

Saxony has been registered with FINRA since 2002. Saxony has its main offices in St. Louis, Missouri and employs approximately 100 registered representatives at the firm’s 50 branch offices.

Nontraditional ETFs are designed to return a multiple of some underlying index or benchmark such as the Dow Jones, S&P 500, or other targeted index. Some nontraditional ETFs return the inverse of that benchmark or index. These nontraditional ETFs are supposed to be held only for a one trading session – usually a single day. As a result, the performance of nontraditional ETFs over periods of time longer than a single trading session can be significantly different from the performance of their underlying index or benchmark. Accordingly, Nontraditional ETFs are inherently risky and complex products. FINRA has advised brokerage firms that nontraditional ETFs are typically not suitable for retail investors who plan to hold them for more than one trading session, particularly in volatile markets.

Sunset Financial Services Fined By FINRA Over Nontraditional (Leveraged) ETF Sales

October 16, 2013 | by Staff Attorney

Between March 16, 2009, and September 21, 2012, FINRA alleged that Sunset Financial Services, Inc., (Sunset) failed to establish and maintain a supervisory system regarding the sale of leveraged or inverse exchange-traded funds, otherwise known as nontraditional ETFs, that was reasonably designed to comply with NASD Conduct Rule 3010.

Sunset has its principal offices in Kansas City, Missouri and is wholly-owned by Kansas City Life Insurance Company, Inc., an insurance company. Sunset has approximately 302 branch offices, 504 registered individuals and 197 non-registered individuals associated with the firm.

FINRA alleged that Sunset’s written supervisory procedures did not address the selling of nontraditional ETFs in any fashion. A leveraged ETF employs financial debt in order to amplify the returns of an underlying stock position. Leveraged ETFs are generally available for most indexes like the S&P 500 and Nasdaq 100. For example, a leveraged ETF with 300% leverage will return 3% if the underlying index returns 1%. Nontraditional ETFs can also be designed to return the inverse of the benchmark.