FAIR Canada published a report on May 14, 2009 entitled "Heads You Lose, Tails You Lose: The Strange Case of Leveraged ETFs". Since then there have been a number of encouraging developments:
(1) The self-regulatory organizations, IIROC in Canada and FINRA in the U.S., have issued notices to their members alerting them to the dangers of these products, and reminding members of their due diligence and suitability obligations to their customers.
(2) The financial press has covered the issue extensively and seems interested in follow-ups.
(3) Morningstar, index investing pioneer John Bogle and other observers continue to issue reports educating the financial industry, regulators and hopefully retail investors about the products.
(4) Prospectus disclosure is slowly improving in both Canada and the U.S.
However, much remains to be done.
(1) Prospectus disclosure for leveraged, inverse and commodity ETFs needs to be further improved to meet the standard of "full, true and plain" disclosure. Listing every risk factor in technical language requiring a law degree and CFA designation to understand does not meet the statutory disclosure requirement. The prospectus should state in plain language that these are day trading products for sophisticated investors and that they do not correlate with the relevant index or commodity over periods longer than a day.
(2) Improved prospectus disclosure is not enough - most investors do not read the prospectus. Regulators need to enforce prohibitions on misleading disclosure in advertising and marketing. Advertising should not imply that these are products suitable for most retail investors (including suggestions that they are suitable for RRSPs and TFSAs). We need warnings on advertising for leveraged ETFs; for example, pop-up risk descriptions in plain language on web sites and for customers buying them from on-line brokers.
(3) Regulators and the financial industry need to rethink how to regulate exotic derivative based products - whether leveraged and inverse ETFs, structured closed-end funds, Asset Backed Commercial Paper (ABCP) or others. Any product that holds complicated derivatives should be regulated more tightly. These very different products should be identified by a different name. Standard ETFs hold shares or bonds. Leveraged, inverse and commodity ETFs hold cash and derivative contracts. FAIR Canada suggests calling them Listed Derivative Products, LDPs. Regulators might consider whether specific risk disclosure with signed customer acknowledgement of risks should be required, as with options and futures contracts.
(4) The TSX, the financial press and others need to take a more critical view of these products with the goal of protecting individual investors, even if the manufacturers of these products are major clients.
FAIR Canada calls for the Canadian Securities Regulators to Step Up
Canadians need the statutory regulators to act decisively to protect investors. The provincial securities commissions are responsible for supervising the issuers of leveraged and inverse ETFs. The statutory regulators set prospectus disclosure standards and review prospectuses for compliance with those standards. They also establish the rules governing advertising of leveraged, inverse and commodity ETFs.
Some specific steps for the Canadian regulators to consider:
(1) Insist on better plain language prospectus disclosure of risks and of how these exotic ETFs work.
(2) Implement risk disclosure and acknowledgment requirements for any retail investor who wishes to trade these products.
(3) Issue specific guidance on advertising and require warnings on both advertising materials and websites. Enforce restrictions on misleading advertising through disciplinary proceedings.
(4) Undertake research into all of the issues posed by leveraged, inverse and commodity ETFs, as well as other structured products which hold derivatives. This study should not be a substitute for steps 1 through 3.
Urgent action to protect investors is needed now.
Click here to read full report - The Strange Case of Leveraged and Inverse ETFs, Part 2: A Few Steps Forward; Much Remains to be Done
Ilana Singer is a seasoned securities regulator and lawyer, with close to eight years of experience with the Ontario Securities Commission. In her most recent role as Senior Advisor, International Affairs, Ilana focused on shareholder and investor rights from a global perspective. Ilana's deep understanding of securities markets and regulation stems from her domestic and international work at the OSC, as well as her experience as a corporate and securities lawyer at McMillan LLP. 