FINRA: A Year in Review, Part 1

Posted on January 11, 2013

The Financial Industry Regulatory Authority (FINRA) has released its end-of-the-year report card on various regulatory achievements it made in 2012, along with progress highlights in detecting fraudulent activity, increasing transparency of securities markets and protecting investors.

Among FINRA’s key accomplishments in 2012:

• Fines totaling $68 million were assessed.
• A record $34 million in restitution to harmed customers was ordered.
• 1,541 disciplinary actions (an increase of 53 from 2011) were brought against FINRA-registered individuals and firms.
• 30 firms were expelled from the securities industry; 294 individuals were barred; and 549 brokers were suspended from association with FINRA-regulated firms.
• 692 matters involving potential fraudulent conduct were referred by FINRAs Office of Fraud Detection and Market Intelligence (OFDMI) to the Securities and Exchange Commission (SEC) and other federal or state law enforcement agencies, including 347      insider trading referrals and 260 fraud referrals.

Disciplinary actions levied by FINRA in 2012 entailed several high-profile cases involving complex financial products, including exchange-traded funds (ETFs), structured products and non-traded REITs, as well as research analyst conflicts, inadequate disclosure and mispricing.

Among the 2012 cases: David Lerner Associates. FINRA sanctioned David Lerner Associates, the firms founder, President and CEO, and the firms head trader in an action related to the non-traded Apple REITs involving suitability and supervision violations. The settlement also consolidated numerous matters, including a municipal and CMO markup case, a pending enforcement investigation of more recent municipal and CMO markups, and 10 pending market regulation matters involving municipal markups identified through surveillance reviews.

FINRA also sanctioned Citigroup Global Markets, Inc; Morgan Stanley & Co. LLC; UBS Financial Services; and Wells Fargo Advisors, LLC a total of more than $9.1 million for selling leveraged and inverse ETFs without reasonable supervision and for not having a reasonable basis for recommending the securities. Fines totaling more than $7.3 million were levied against the firms, which were required to pay a total of $1.8 million in restitution to certain customers who made unsuitable leveraged and inverse ETF purchases. Similar cases were brought by FINRA against Merrill Lynch and Scott & Stringfellow.

Finally, Merrill Lynch was fined $450,000 for supervisory failures relating to sales of structured products to retail clients. The firm relied upon automated exception-based reporting systems to flag transactions and/or accounts that met certain pre-defined criteria, but did not specifically monitor for potentially unsuitable concentration levels.

Check back for Part 2 of FINRA’s 2012 Year in Review and the various investor protection and transparency initiatives launched in 2012.

Complex Investment Products in Hot Water With FINRA

Posted on January 20, 2012

Brokerage firms and registered reps selling private placements, inverse and leveraged exchange traded funds (ETFs), structured notes and other complex investment products have been put on notice by the Financial Industry Regulatory Authority (FINRA). In a newly issued regulatory notice, FINRA outlined certain due-diligence and supervisory policies and procedures that firms must have in place when selling such products and that the investments themselves can be expected to face greater regulatory scrutiny in the future.

“Registered representatives should compare a structured product with embedded options to the same strategy through multiple financial instruments on the open market, even with any possible advantages of purchasing a single product,” Regulatory Notice 12-03 said in part.

As in previous notices issued by FINRA, Notice 12-03 reiterated the fact that firms should consider whether less complex products can achieve the same objectives for investors. The notice further stated that post-approval follow-up and review are particularly important for any complex investment product.

In recent years, regulators have issued a number of enforcement and disciplinary actions in cases involving complex investments. Two high-profile cases occurred in 2009, when the Securities and Exchange Commission (SEC) filed fraud charges against Medical Capital Holdings and Provident Royalties LLC over the private placements issued by both entities.

Several state regulators, including Massachusetts. also have filed regulatory actions against various broker/dealers that sold Medical Capital and Provident private placements to investors.

ETFs: Look Beneath the Surface

Posted on January 13, 2012

The world of exchange-traded funds may look like a mass of liquidity and fast profits but lurking just beneath the surface is an array of potential risks and financial mayhem.

Exchange-traded funds are baskets of investments such as stocks, bonds, commodities, currencies and options that track market indexes. But in recent years, traditional ETFs have become increasingly complex, delving into esoteric and risky areas that involve swaps, futures contracts and other derivative instruments.

Leveraged and inverse ETFs are two of those esoteric products. Leveraged ETFs are designed to deliver “multiples” of the performance of the index or benchmark they track. Its cousin, the inverse ETF. works in the reverse by trying to deliver returns that are the opposite of the index’s returns.

The problem many investors make with leveraged and inverse ETFs is that they hold these investments for longer than one trading day. Leveraged and inverse ETFs are not designed for long-term returns. Rather, they try to achieve their stated performance objectives on a daily basis. Holding a leveraged or inverse ETF for any longer may not get you the multiple of the index return you were expecting and instead create a financial nightmare.

As reported Jan. 13 by Businessweek. ETFs surpassed $1 trillion in assets globally in 2009. The growth has not gone unnoticed by regulators, especially as more complex and riskier versions of the ETF emerged in the market.

For example, the Securities and Exchange Commission (SEC) began examining whether ETFs that use derivatives to amplify returns may have contributed to equity-market volatility in May 2010, when the Dow Jones Industrial Average plunged some 1,000 points in one hour. At the time, the SEC stated that any new ETFs that made substantial use of derivatives would not be approved.

Congress also has taken an interest in the more complex and riskier versions of ETFs, holding several hearings in 2011 on synthetic ETFs and their transparency, leverage and use of derivatives.

So in a nutshell: Leveraged and inverse ETFs aren’t for everyone. In fact, they may not be suitable investments for most retail investors. Not only are these synthetic products complex, highly risky and lack transparency, but they require detailed knowledge and constant monitoring. And while there could be instance where certain trading and hedging strategies justify holding a leveraged or inverse ETF for longer than a single trading day, there’s an even higher probability of losing money.

Leveraged, Inverse ETFs: A Jekyll & Hyde Investment?

Posted on January 3, 2012

Leveraged and inverse exchange-traded funds (ETFs) are getting a bad and perhaps well deserved reputation. Critics have coined an endless array of negative descriptors for these products, from “toxic,” to “dangerous,” to “pumped-up investment vehicles with a mountain of risks.”

The characterizations are not without some merit. The Securities and Exchange Commission (SEC), the North American Securities Administrators Association and the Financial Industry Regulatory Authority have issued separate and joint warnings to investors about leveraged and inverse exchange-traded funds. Among their concerns: the growing complexity of the products, their lack of transparency and the potential for investors to experience significant financial losses if they hold onto their funds for more than one trading day.

The first exchange traded fund was launched in 1993. As the products evolved, so did the level of risk. In 2006, ETFs became more aggressive with the introduction of leveraged and inverse exchange-traded funds to the market.

Exchange-traded funds are baskets of investments such as stocks, bonds, commodities, currencies, options, swaps, futures contracts and other derivative instruments that are created to mimic the performance of an underlying index or sector. Leveraged and inverse ETFs, however, are something altogether different. They are not your standard variety of exchange-traded funds.

Leveraged ETFs seek to deliver “multiples” of the performance of the index or benchmark they track. Inverse ETFs do the reverse. They try to deliver the opposite of the performance of the index or benchmark being tracked.

Many investors are under the mistaken belief that a leveraged ETF will give them twice the daily return of the underlying index over the long term. In reality, nothing could be further from the truth.

In recent years, there’s been an increase in arbitration claims and investor lawsuits involving leveraged and inverse exchange-traded funds. The trend is likely to continue in 2012. Moreover, the number of ETFs that have been shut down or liquidated is on the rise, up 500% in each of the past three years over 2007 levels, according to a recent investor alert by the North American Securities Administrators Association. That amounts to one ETF a week.

For investors, these liquidations often prove costly in the form of termination fees, as well as lost opportunity costs if the providers convince investors to stay in the fund through the liquidation process to save on commission costs.

The bottom line: Not all ETFs are the same. While some may be appropriate for long-term holders, others require daily monitoring. The best advice: Know your investment objectives and risk tolerance levels before making the ETF leap.

The Ongoing Dangers of Synthetic ETFs

Posted on November 17, 2011

Synthetic exchange-traded funds (ETFs) have gotten a bad rap lately and with good reason. Regulators and many financial experts believe that synthetic ETFs are too complex for retail investors and that they may not fully understand the counterparty and derivatives risks they are actually taking on.

Many synthetic exchange-traded funds rely on derivatives to generate returns instead of holding or owning the underlying securities as traditional ETFs do. Synthetic ETFs include inverse and leveraged funds. A leveraged ETF is designed to accelerate returns based on the rate of growth of the index being tracked. For example, if the underlying index moves up 3%, a 2x leveraged ETF would move up by 6%.

An inverse ETF does the opposite. It is designed to perform as the inverse of whatever index or benchmark is being tracked. Inverse ETFs funds work by using short selling, derivatives and other techniques involving leverage.

And with leverage, there always comes risk. As reported Nov. 17 by Investment News. Laurence D. Fink, chief executive officer of BlackRock, Inc. is a staunch critic of some exchange-traded funds. In particular, Fink takes issue with ETFs provided by Societe Generale SA.

If you buy a Lyxor product, youre an unsecured creditor of SocGen, said Fink in the Investment News story. Providers of synthetic ETFs should tell the investor what they actually are. Youre getting a swap. Youre counterparty to the issuer.

And therein is the problem.

Counterparty risk means there is a chance that the swap provider could go belly up, leaving investors out in the cold. Remember Lehman Brothers? Following Lehmans collapse in 2008, many investors quickly discovered that their investments were essentially worthless.

Inverse/Leveraged ETFs a Concern For Investors

Posted on November 10, 2011

Whats wrong with inverse or leveraged exchange-traded funds (ETFs)? Plenty, if you dont fully understand how the products actually work or the risks involved.

Inverse or leveraged exchange-traded funds are considered synthetic funds, and they are complicated products that often entail much more risk than traditional ETFs. Leveraged ETFs use borrowed money in the form of swaps or derivatives to double or triple the daily returns on a stated index. Inverse ETFs do the opposite. Instead of tracking the fund to the performance of an index, the price of an inverse ETF moves in a direction opposite to the daily movement of its index.

In the past year, synthetic funds have come under growing scrutiny by regulators over concerns that investors may not be aware of the risks that the products pose. Earlier this summer, the Financial Industry Regulatory Authority (FINRA) issued a regulatory notice on leveraged and inverse ETFs. Among other things, FINRA said that the complexity of inverse and leveraged ETFs made them unsuitable for any retail investor who planned to hold on to them for longer than one trading session.

Unfortunately, many investors failed to heed FINRAs warning because their advisors never thoroughly explained the fine print associated with leveraged and inverse exchange-traded funds. Instead, investors held their investments for much longer periods of time, only to see returns that were vastly different from what they were promised by their financial advisers. This particular scenario has become more frequent over the past year as volatility in the financial markets made performance surprises in the ETF market the norm rather than the exception.

The bottom line: If youre thinking about investing in leveraged or inverse exchange-traded funds, think long and hard before taking action.

Exchange-Traded Funds Face SEC Scrutiny

Posted on October 20, 2011

Exchange-traded funds (ETFs) are the latest investment product to find themselves in the hot seat with the Securities and Exchange Commission (SEC). At a Senate Banking subcommittee hearing held today, the SEC announced that it was launching a sweeping review of exchange-traded funds.

Among other things, the SEC says it will be looking at investor disclosures, the transparency of the underlying instruments in which ETFs invest, liquidity levels, fair valuations, and the potential impact of ETFs on market volatility.

The SECs review also entails gathering and analyzing detailed information about specific products, said SEC Investment Management Director Eileen Rominger.

Recent scrutiny of exchange-traded products has been fueled, in part, by the growth of more complex exchange-traded products that many experts contend are far too complex and confusing for the average retail investor. In particular, regulators are concerned about leveraged and inverse ETFs funds designed to amplify short-term returns by using debt and derivatives.

Problems With Exchange-Traded Funds

Posted on September 6, 2011

Exchange-traded funds (ETFs) have exploded in popularity over the years, but they also come with a number of potential drawbacks. Earlier this summer, the North American Securities Administrators Association (NASAA) expressed concern in an advisory notice that many investors may not fully understand the hidden risks associated with ETFs or how the investments actually work until it’s too late.

“As with any investment, investors should know what they are investing in. They should understand the risks, costs and tax consequences before investing in ETFs. Check under the hood,” said NASAA President and North Carolina Deputy Securities Administrator David Massey in a June 27 ETF notice.

Exchange-traded funds started in 1993 when State Street sponsored the first ETF in the form of the SPDR Trust. The investments which are designed to mimic the performance of an underlying index or sector can be characterized as baskets of investments, and include stocks, bonds, commodities, currencies, options, swaps, futures contracts and other derivative instruments.

The problem is that all ETFs are not created equal. Some traditional ETFs may be appropriate for long-term investors, but other ETFs, such as exotic leveraged and inverse ETFs, may require daily monitoring, notes NASAA in its June ETF notice.

Other risks associated with some ETFs include liquidity. Does the value of the ETF equal that of its underlying securities? The number of ETFs that have been shut down or liquidated is up 500% in each of the last three years over 2007 levels. That comes to one ETF every week.

Huge fees are another issue investors need to be aware of when it comes to some exchange-traded funds. For example, leveraged and inverse ETFs must be traded all the time; that means you will pay a commission or fee each time a share is bought or sold.

The bottom line: The complexity, potential risks and substantial fees of exchange-traded funds may make them unsuitable investments for some investors.

Leveraged, Inverse ETF Sales Grow, Along With Risks

Posted on November 12, 2010

Sales of specialized exchange-traded funds (ETFs) are on the rise. And so is the risk, including liquidity concerns, hidden costs, and overall structure.

Despite these issues, many investors have become enamored with ETFs and, in particular, inverse and leveraged ETFs on the advice of their broker. Inverse ETFs are constructed by using derivatives that, in turn, create a security. This security then profits from a decline in the underlying index or benchmark.

This year, inverse and leveraged ETFs became the subject of scrutiny from the North American Securities Administrators Association, which placed the products on its watch list of “investor traps.”

Similarly, the Securities and Exchange Commission (SEC) and the Financial Industry Regulatory Authority (FINRA) have both issued notices to investors about the risks associated with leveraged and inverse ETFs.

Leveraged and inverse ETFs typically are designed to achieve their stated performance objectives on a daily basis. Some investors, however, might invest in these ETFs with the expectation they may meet their stated daily performance objectives over the long term, as well. What many investors fail to realize is that the performance of leveraged and inverse ETFs over a period longer than one day can differ significantly from the stated daily performance objectives of the products.

Leveraged, Inverse ETFs Back In News

Posted on September 21, 2010

Concerns about the suitability of leveraged, inverse exchange-traded funds (ETFs) for individual investors may cause Morningstar to stop its 1-to-5 rating of the products. The company may remove the ETFs from broader fund categories altogether and instead place them in a separate group, according to a Sept. 20 story in Bloomberg.

The reason for the possible change is that the ratings are designed for investment vehicles, and leveraged ETFs are trading vehicles. The products use derivatives and debt to amplify the returns of a market index, while inverse funds profit from declines in an underlying benchmark.

In an effort to determine whether investors needed additional protections regarding leveraged ETFs, the Securities and Exchange Commission (SEC) stopped approving new ETFs that made significant use of derivatives in March. Several months later, both the SEC and the Financial Industry Regulatory Authority (FINRA) issued a notice to investors on leveraged ETFs.

Among other things, the regulators cautioned investors about the products and stated that they may be inappropriate for long-term investors because returns can potentially deviate from underlying indexes when held for longer than a trading day.