What do these stories all have in common?
- An event planner loses over $100,000 shorting a 3X inverse leveraged exchange traded note;1
- Individual investors lost their investments in mortgage REIT and crude oil leveraged ETNs during the real estate and crude oil collapse earlier this year;2 and
- Retail investors poured money into an oil-futures linked ETF this Spring, many not understanding that the price of a share of the ETF was not the same as the price of a barrel of oil.3
Besides the obvious ("what were they thinking?"), one has to wonder why retail investors are purchasing products, many of which plainly state in their prospectuses that they are designed as short-term investments for sophisticated investors who track their portfolios on a daily basis, and that state that the products are not designed to be long-term investments.
The Securities and Exchange Commission ("SEC") responded to the dislocations in the markets for leveraged inverse products in a joint statement by Chairman Jay Clayton, Dalia Blass, Director, Division of Investment Management, William Hinman, Director, Division of Corporation Finance, and Brett Redfearn, Director, Division of Trading and Markets (the "Joint Statement").4
The Joint Statement noted that retail investors may not appreciate that times of "market stress ... typically have a disproportionate impact on complex products, such as leveraged/inverse products ...." The SEC acknowledged that these types of products "have operated in accordance with their terms," but the "pricing and trading dynamics of these products during the spring market was not consistent with investor expectations."5
In other words, the issue isn't disclosure, it's investor education. With greater access to trading sites,
"self-directed retail investors are typically making investment decisions on their own accord via online trading platforms and without the assistance of a financial professional. In other words, these self-directed investors do not have the required protections that apply when they receive investment advice from a broker or investment adviser, who must understand, and may explain if necessary, the characteristics and potential risks and rewards of the investment, and determine that it is in the best interest of the retail customer."6
If these investors had purchased their complex products through a broker-dealer or RIA, they would have benefitted from certain protections. However, as the SEC stated, "Regulation Best Interest and an investment adviser's fiduciary duty do not apply where a retail investor invests on his or her own accord in complex products through a self-directed account."7
How can the SEC protect self-directed retail investors independently selecting complex products, which they may not fully understand? The staffs of the Divisions of Investment Management, Corporation Finance and Trading and Markets will be reviewing the effectiveness of current regulations as they relate to retail investors with self-directed accounts who buy leveraged/inverse and other complex products. The results may be potential new rulemaking, guidance or other policy actions. Also, the staff "may consider ... additional obligations for broker-dealers and investment advisers relating to complex products ... point of sale disclosures and procedures tailored to the risks of complex products."8
Originally published in REVERSEinquiries: Volume 3, Issue
Click here to read the articles in this latest edition.
1. "Runaway ETNs Trap Investors in the 'Wild West' of Index Investing," The Wall Street Journal (Oct. 19, 2020).
2. "'Bankrupt in Just Two Weeks; - Individual Investors get Burned by Collapse of Complex Securities," The Wall Street Journal (June 1, 2020).
3. "Oil Market's Crisis Spreads to Individual Investors," The Wall Street Journal (Apr. 22, 2020).
4. The October 28, 2020 Joint Statement is available at: https://bit.ly/32hN1AE.
5. See the Joint Statement at Section 2.
6. Id. at Section 3.
7. Id. at Section 4.
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