New guidance note emphasizes dealer members’ obligations with respect to suitability, communications, and supervision
While leveraged and inverse ETFs might be used as tools to juice return performance for certain underlying asses or indexes, they can also be too hot for many buy-and-hold investors – and dealer members must keep those risks in mind as they sell the products.
That’s according to the Investment Industry Regulatory Organization of Canada (IIROC) which issued the guidance note among many others in torrent of updates late last week.
“While such products may be useful in some sophisticated trading strategies, they are highly complex financial instruments that are typically designed to achieve their stated objectives on a daily basis,” IIROC said. “Due to the effects of compounding, their performance over longer periods of time can differ significantly from their stated daily objective.”
In its note, IIROC observed that inverse ETFs – some of which are also leveraged – are often marketed as a means for investors to capitalize on or hedge against downward movements in the market. But because most leveraged and inverse ETFs “reset” daily, their performance over longer periods of time can differ significantly from their stated objectives due to the effects of compounding.
The guidance reminded dealer members that part of their suitability analysis of products requires having an understanding of those products. “With respect to leveraged or inverse ETFs, this means that a firm must understand the terms and features of the funds, including how they are designed to perform, how they achieve that objective, and the impact that market volatility, the ETF’s use of leverage and the client’s intended holding period will have on their performance,” IIROC said.
The dealer must also determine a product’s suitability for specific clients by considering current information on the client’s financial situation, investment knowledge, objectives, and risk tolerance; the client’s account investment portfolio composition and risk level; and any other matter of relevance to the product or the client’s account.
“While the client-specific suitability analysis depends on the investor’s particular circumstances, leveraged and inverse ETFs typically are not suitable for retail investors who plan to hold them for more than one trading session, particularly in volatile markets,” IIROC said.
Sales materials and oral presentations, the self-regulator said, must also present a fair and balanced picture of both the benefits and risks of leveraged ETFs and inverse ETFs, not omitting any material fact or qualification. It also reminded dealer members that including risk disclosures in a prospectus or product description does not make up for deficiencies in disclosure within sales materials, even if the prospectus or product disclosure accompanies or immediately precedes the sales materials.
Dealer members, IIROC added, should have an appropriate supervisory system, with written procedures to ensure their registered persons comply with applicable securities laws when recommending any product, including leveraged and inverse ETFs. Dealer firms, it noted, should also document the steps that they have taken to ensure adherence to the procedures.
In training their registered persons to sell leveraged and inverse ETFs, IIROC said firms should emphasize the need to understand and consider the risks, including the client’s objectives and how longer exposure time and volatility could impact a fund’s performance.
“Training for all persons should emphasize that, due to the complexity and structure of these funds, they may not perform over time in direct or direct inverse correlation to their underlying index,” IIROC said. “This is particularly important as many investors may be turning to these funds as part of a long-term strategy to weather current market conditions.”