Under Section 4(g)(6)B) of the Securities Exchange Act of 1934 as amended, the Investor Advocate of the U.S. Securities and Exchange Commission (“SEC”) is required to prepare a summary of the most serious problems encountered by investors with financial products. Accordingly, in its Report on Activities, Fiscal Year 2020 to the U.S. Congress, the SEC’s Investor Advocate reviewed the risks associated with leveraged and inverse exchange traded funds while discussing the Commission’s recent approval of the final version of the SEC’s Derivatives Rule which removed provisions that would have required investment advisers to exercise due diligence before approving retail investor accounts to invest in leveraged and inverse exchange traded funds (“ETFs”).
In this Report on Activities, the Investor Advocate noted that “the [SEC] has long acknowledged the unique investor protection concerns that leveraged/inverse investment vehicles present. Numerous enforcement cases … have shown that investment professionals themselves often lack a basic understanding of these complex [leveraged and inverse ETFs] ….” However, the Investor Advocate pointed out that on the same day that the Derivates Rule was finalized, the SEC Chairman and 3 Division Directors issued a joint statement “recognizing the unique dangers presented by leveraged and inverse ETFs.” The Investor Advocate explained further that the joint statement explained these leveraged and inverse ETFs and other complex products “may present investor protection issues— particularly for retail investors who may not fully appreciate the particular characteristics or risks of such investments,” expressed concern that “retail investors, and in certain cases financial professionals, may not fully appreciate how these types of products operate,” and stated “investor protection concerns are heightened, moreover, in times of market stress, which typically have a disproportionate impact on complex products, such as leveraged/inverse products….” As a result, the Investor Advocate found it “puzzling” that that this joint statement included a statement that the SEC staff would review the effectiveness of final version of the Derivatives Rule with respect the special investor protection concerns presented by complex financial products since investor protection concerns about leveraged and inverse ETFs are longstanding and already well-documented.
In light of this anticipated review by SEC staff focused on the use of leveraged and inverse ETFs with retail investors, RIA Compliance Consultants recommends that an investment adviser firm review whether it (a) uses leveraged or inverse ETFs in an appropriate manner which is in the best interest of each client, (b) has adequate policies and procedures regarding the use of such ETFs, (c) properly trains its investment adviser representatives on leveraged and inverse ETFs and (d) follows any written policies and procedures as it relates to ETFs.
For your convenience, a sample investment adviser compliance section, WSP/CoE Section Update – Inverse & Leveraged ETFs, is available to investment advisers currently subscribed to our Annual Compliance Program (Bronze, Silver, Gold & Platinum Packages) or can be purchased on a la carte basis. Likewise, a sample investment advisory client acknowledgement, Suitability – Leveraged/Inverse ETFs – Client Acknowledgement, is available to investment advisers subscribed to our ACP Platinum Package or can be purchased on a la carte basis.
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SEC Enforcement Action – ETFs and Failure to Follow Policies and Procedures (February 15, 2017).
Investment Adviser Compliance Resources for Leveraged & Inverse ETFs: