Sales of Leveraged and Inverse ETFs Expose Wall Street Firms to Liability for Misrepresentation and Unsuitable Recommendations


Fidelity Investment has joined Charles Schwab and Morgan Stanley Smith Barney in warning customers about the complexity and risks of Leveraged Exchange Traded Funds (ETFs), reported Daisy Maxey in her article, “Fidelity the Latest to Caution on ETFs,” published in the August 4 Wall Street Journal. Fidelity’s web site now states: “Most [Leveraged ETFs] reset daily and seek to achieve their objectives on a daily basis. Due to compounding, performance over longer periods can differ significantly from the performance of the underlying index.”

The Financial Industry Regulatory Authority (FINRA) has come out with a regulatory notice saying, in effect, that Leveraged ETFs are unsuitable for most investors. They use borrowed money to double or triple the performance of an underlying benchmark, while Inverse ETFs move in the opposite direction to their benchmark. During the 12 month period ending July 24, 2009, 55% of Leveraged ETFs and nearly 88% of Inverse ETFs were “flipped,” i.e., investment in them lost money when the underlying benchmarked gained, and vice versa. Due to compounding, the flips can be large. In one of FINRA’s examples, an ETF seeking to deliver three times the daily return of the Russell 1000 Financial Services Index fell 53 percent while the index actually gained around 8 percent. The related ETF seeking to deliver three times the inverse of the index’s daily return declined by 90 percent over the same period.

Fidelity did not return a call seeking comment for Ms. Maxey’s article. But as of last week, Fidelity said it would still sell Leveraged ETFs to customer who wish to purchase them, presumably including retail customers who, as Fidelity knows, have no business purchasing them.

Sales of Leveraged and Inverse ETFs have “exploded” providing needed revenues to Fidelity and other sellers. Are Fidelity’s and other sellers’ warnings really meant to reduce the volume of sales of these products to investors by providing a full and fair disclosure of all material risks? Or are they meant to provide a boilerplate cover (take only as directed, void where prohibited) as those firms continue unsuitable sales of the products?

These firms may honestly believe that they are not “recommending” the products they offer and sell, but FINRA’s position is that a statement (for example in a web posting or sales materials) that brings leveraged or inverse ETFs to the attention of customers or could reasonably be expected to influence a customer to purchase leveraged or inverse ETFs will be considered to be a recommendation subjecting the firm to the suitability rules. (NASD Notice to Members 96-60; FINRA Incorporated NYSE Rule Interpretation, Rule 472/09.) Since FINRA has also notified its member firms that such recommendations are almost always unsuitable (FINRA Notice to Members 09-31), most investors who have suffered losses in such products have compelling claims to recover their losses.

Page Perry is an Atlanta-based law firm with over 125 years collective experience representing investors in securities-related litigation and arbitration. While past results are not indicative of future success, Page Perry’s attorneys have recovered over $1,000,000 for clients on more than 30 occasions. Page Perry’s attorneys are actively involved in counseling institutional and individual investors regarding their ETF investment problems. For further information, please contact us.