Suitability Requirements Concerning Leveraged and Inverse Exchange-Traded Funds

FINRA declares that inverse and leveraged ETFs that are reset daily typically are unsuitable for retail investors who plan to hold them longer than one trading session, particularly in volatile markets!

Particular Features of Leveraged and Inverse Exchange Traded Funds (ETFs)

1) Typically designed to achieve stated results on a daily basis, which can lead to significantly different performance from the index or benchmark over extended periods of time due to compounding;

2) Seek to deliver multiples of performance of the index or benchmark they track. Some of these ETFs are “short” or seek to deliver the inverse or opposite performance of the index or branch they track.

3) Use swaps, futures contracts and other derivatives to produce multiple rates of return.

Two Separate Parts to Suitability Analysis under NASD Rule 2310

Before recommending the purchase, sale or exchange of a security, a firm must have a reasonable basis for believing that the transaction is suitable for the customer to whom it is recommended.

A) Product Suitability;

i) Is the leveraged exchange traded fund (ETF) suitable for any customer?

ii) Does the broker dealer (BD) understand the leveraged exchange traded fund (ETF) terms and features, etc?

iii) Does the registered representative (RR) understand the leveraged exchange traded fund (ETF) features and terms, etc?

iv) For both ii) and iii) is the how the fund is designed to perform, how it achieves those objectives, the impact on performance of market volatility, the use of leverage and the appropriate holding period for the exchange traded fund (ETF)

B) Customer Suitability.

i) Is the leveraged exchange traded fund (ETF) suitable for the customer to whom it is recommended?

ii) To determine this suitability, look at the customer’s:

a) Tax status;

b) Financial status;

c) Investment objectives; and

d) risk tolerance.

Supervision under NASD Rule 3010’s requirements

● SEC and FINRA rules are followed by broker-dealers (BD) and registered representatives (RR)

● Promotional materials are fair and balanced and not inaccurate

● Broker-dealer (BD) conducts the product suitability analysis

● Registered representative (RR) conducts the client specific suitability analysis

May Law, PC is a securities and commodities boutique firm that has a an extensive knowledge of FINRA related rules and assists registered broker-dealers (BDs) and associated persons (APs) in responding to FINRA investigations, disciplinary matters and routine one the record interviews (OTRs). The firm’s website is located at www.maylawpc.net, and the main number is 847-675-1052. Andrew May has been practicing law for 17 years and can be contacted at amay@maylawpc.net.

© 2012 May Law, PC

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1 Comment

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One response to “Suitability Requirements Concerning Leveraged and Inverse Exchange-Traded Funds

  1. In a speech delivered at the SIFMA Complex Products Forum in September 2012, FINRA Chairman RIchard Ketchum cautioned brokerage firms and brokers that they should also monitor market developments after the sale of leveraged and inverse ETF’s, since market changes could expose customers to increased risk.

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