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FINRA Drops the Hammer on Leveraged ETFs

The regulatory group places the burden for education and suitability on brokers and advisors.

Scott Burns, 06/23/2009

It appears that as we were writing our call for increased oversight on leveraged and inverse funds, FINRA was posting a response of its own. I'm not exactly on the FINRA distribution list, so I thank Jim Wiandt at Index Universe for bringing this filing to my attention.

In its regulatory ruling, FINRA warns of the risks of these funds and reminds financial advisors of their fiduciary responsibilities regarding the marketing, suitability, and understanding of these products. The ruling also calls on advisor firms to have adequate supervisory procedures in place to ensure that these obligations are met. For the providers of these products, FINRA reminds that all marketing material must include the disclosure about the daily return period and daily rebalancing in addition to warnings about what return patterns will look like over the long term.

The following quote from the piece sums up its take about as well as a single sentence could: "While the customer-specific suitability analysis depends on the investor's particular circumstances, inverse and leveraged ETFs typically are not suitable for retail investors who plan to hold them for more than one trading session, particularly in volatile markets."

We couldn't have said it better ourselves. This is a huge step forward toward protecting individual investors from having exposure to these products unwittingly inserted into their portfolios. We hope that platform advisory firms and registered independent advisors alike will get the message. It will also give us at Morningstar a regulatory leg to stand on when dealing with questions from individuals and advisors alike regarding the use of these funds.

Under the assumption that most large trading platforms are also registered with FINRA, this would mean that the ruling would also cover most individual or self-directed investors. How these firms would conform to that ruling is still somewhat nebulous to me, but we are standing by our position that, at the very least, these products should be subject to the same approval standards and safeguards as individual derivative securities.

You could read between the lines a little bit on this ruling and say that certain portions of it would also pertain to commodity-linked exchange-traded derivative funds. Still, we would encourage FINRA to post a ruling similar to this one that also encompasses the commodity-linked exchange-traded derivative funds and addresses the suitability of these products.

Overall, we applaud FINRA's firm and clear stance on the use of leveraged and inverse ETFs. Placing the burden for education and suitability on the brokers and advisors for these products should go a long way toward keeping them out of the hands of the uninitiated.

Scott Burns is director of ETF analysis at Morningstar and editor of Morningstar ETFInvestor.

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