Suitability Issues for ETFs and ETNs

Suitability Issues for ETFs and ETNs

What can go wrong? With exchange-traded funds and notes, particularly leveraged ones, the mechanics aren’t as straightforward as they seem. Yet there is little excuse for not knowing what you are getting your clients into.

FINRA recently issued two Investor Alerts, one for inverse/leveraged ETFs and one for Exchange Traded Notes (ETNs), warning advisors to make sure they are well versed in the nuances of these structures and that they are suitable for their clients. 

We also received a New York court ruling against the 44 plaintiffs in a suit against ProFunds. The court ruled that ProFunds had adequately disclosed the risks associated with their inverse/leveraged funds and did so “in plain English.”

What this means to investors and advisors is that, along with the regulators and issuers of financial products, we all share the responsibility of educating, and sometimes protecting, investors. 

The issue around ETNs is predominately based on the fact that while they trade like a stock and are listed on an exchange like a stock, ETNs are in fact debt instruments. The main risk of the structure is that you are assuming the credit worthiness of the bank that is issuing the note.  Those risks came into play during the collapse of Lehman Brothers as the bank went bankrupt their notes eventually became worthless. So, the warning from FINRA is clear, know what you are buying before you buy it.

The main risk inherent in the inverse/leveraged ETFs is based on the fact that the fund is rebalanced on a daily basis. If you hold the fund for longer than one day your risk of a dislocation of the fund to the market becomes significantly higher.  Again, know what you are buying.

The challenge that we hear most often from investors and advisors is that the prospectus–the source of the most information regarding these investments—is impossible to read. However, there are other sources.  The issuers’ websites have fact sheets and abbreviated prospectuses available on the specific funds as well as educational material about the structures and the risks. They also have dedicated sales staff that will take your call and walk you through the product.

I applaud the efforts of the regulators and the court rulings. Shared responsibility is where we need to be. Exchange traded products are highly regulated, the structures are approved by the SEC and fully vetted by the exchanges. However that should not lull us to assuming since it is approved for trading that is suitable for all investors.  FINRA, the SEC, the exchanges and the sponsors cannot determine the risk profile of every investor.  However, they can articulate the risks inherent in the product. Advisors and investors need to consume that information in order to best protect their investments.

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