There has recently been a spate of litigation and regulatory activity surrounding exchange-traded funds (ETF’s), particularly leveraged or inverse ETF’s. Both the Securities and Exchange Commission (SEC) and the Financial Industry Regulatory Authority (FINRA) have issued warnings that leveraged and inverse exchange ETF’s are not suitable for most retail investors, and at least one state has announced an investigation into the sales practices of ETF’s. More recently, several class actions have been filed against specific EFT providers, notably ProShares Trust, which is one of the largest providers of leveraged and inverse ETF’s.
ETF’s are stock or bond funds that are sold on stock exchanges. Typically they are index funds that track a benchmark such as the Dow Jones Industrial Average or the S&P 500, although they can be managed. Leveraged EFT’s are a specialized form of ETF that uses leverage, or borrowed money, with the goal of outperforming an index during a trading session or other short-term time frame. For example, a leveraged ETF may attempt to achieve gains that are 2 or 3 times the benchmark index, while an inverse leveraged ETF may attempt to achieve 2 or 3 times the opposite of how the index performs as part of a short selling or hedging strategy. Either way, leveraged ETF’s are much more sensitive to market movements than non-leveraged ETF’s due to the inherent compounding effect of leverage. For example, if a fund uses $1 in cash and $9 worth of credit to acquire $10 worth of securities, then a 10% movement in the price of the securities ($1) means that the fund either doubles its $1 cash investment or loses it completely, depending on the direction of the movement. Because a leveraged ETF can lose many times its value during a single day, only the most sophisticated investors?with the ability to monitor them closely during the market session?should invest in such funds.
According to the SEC and FINRA warnings, ETF’s are generally not suitable for retail investors who intend to hold them for more than a day. ETF providers have responded by stating that ETF’s can be held for more than a day as long as they are properly monitored, but few retail investors have the capacity to do that?which would not only require an intimate understanding of the complex relationship between the ETF and the benchmark, but the ability to recognize deviations in that relationship and to take corrective action before those deviations widen into exponential losses. Retail investors who purchased ETF’s are often misled by ETF advertising that does not provide a balanced view of the risks and benefits of such funds. Moreover, the brokers who recommended the funds for their clients owe an independent duty to recommend suitable investments as well as to fully disclose risks that the broker knows or should have known. There will undoubtedly be much litigation over whether it is the ETF providers, the broker-dealers?or both?who are liable to the investors claiming that were misled.
The focus of the class actions has been on the ETF funds themselves rather than the broker-dealers who sell them. According to Craig T. Jones, an attorney with the Atlanta law firm of Page Perry, “the better claims may be against the brokers who sold ETF’s because the funds themselves will argue that they were designed for carefully monitored trading by sophisticated investors, and that the brokers are at fault if they recommended the funds to clients for whom the funds were unsuitable.” Claims against broker-dealers are less likely to fit into the class action mold, however, since a large number of brokers said different things to lots of different clients, making it difficult for class action lawyers to allege that all plaintiffs were treated similarly enough to justify a class action. According to Jones, “brokers who recommended leveraged ETF’s may have sold other bad investments to the same clients. An investor who lost a lot of money because of a bad broker, not just in ETF’s but also due to other unsuitable investments, might be better off pursuing a recovery against the broker for all of his losses rather than trying to blame the ETF losses on the fund provider and the rest on the broker.”
Jones recommends that anyone who has suffered significant ETF losses contact a lawyer to evaluate the individual merits of his or her claim. “If the ProShares class actions are ultimately certified by the courts, it may be that some investors are better off participating in the class action. But others may be better off opting out and pursuing their own claims?particularly if they have other losses that they believe were the fault of a broker who was not looking after their interests.” Class actions have become more difficult for investors to win due to recent reform legislation and court decisions, but even where the courts allow them to go forward, class actions generally take many years to resolve. On the other hand, an investor with a viable claim against a broker-dealer can often get his or her claim resolved by arbitration in 12 to 18 months, but Jones stresses that every case is different. “If you will give me or another lawyer a call,” says Jones, “we can advise you with respect to your own individual options and let you make an informed decision that is best for you.” Jones’ law firm, Page Perry, is based in Atlanta but handles investor claims all over the country.