IIROC issues strong warning on ETFs

Leveraged exchange traded funds (ETFs) are probably not suitable for retail investors, the Investment Industry Regulatory Organization of Canada is warning its dealer members.

IIROC is compelled to issue a warning to its dealer members about the risks associated with leveraged ETFs. The wording and examples of the warnings are very similar to warning issued by its U.S. counterpart, the Financial Industry Regulatory Authority.

Amongst the fastest growing securities in Canada in terms of daily trading volume, leveraged ETFs will deliver either two times correlated or inverse performance of the index they track. If used properly they can be a powerful hedging tool for a portfolio, however there are serious risks associated with buy and hold strategies using them.

Leveraged ETFs are reset daily by the provider. This means if an investor does not rebalance their leveraged ETFs on a daily basis, there will be tracking error, which will be exacerbated the longer the investment is held.

Investors need to have both the right call on a market direction, and more importantly a stable path of direction for these products to work in buy and hold strategies. Volatility can seriously impair the performance of these ETFs if held for the long term.

In its notice IIROC said a Canadian ETFs that seeks to deliver twice the daily return of the COMEX Gold Bullion Index fell 5% between January 22, 2008 and May 29, 2009. However, its inverse fund (twice the inverse daily return of the index) fell 38% in the same time period even though the underlying COMEX Gold Bullion Index increased by 6% during this period IIROC.

“Due to the effects of compounding, their performance over longer periods of time can differ significantly from their stated daily objective. Therefore, leveraged and inverse ETFs that are reset daily typically are unsuitable for retail investors who plan to hold them for longer than one trading session, particularly in volatile markets,” the notice says.

IIROC is urging both dealers and registrants to ensure that if they offer leveraged ETFs to client, that it is indeed a suitable investment for that particular client, in accordance with Dealer Member Rules 1300.1(p) and (q).

“With respect to leveraged or inverse ETFs, a firm must understand the terms and features of the funds, including how they are designed to perform, how they achieve that objective, and the impact that market volatility, the ETF’s use of leverage and the customer’s intended holding period will have on their performance. Dealer Members may find it helpful to refer to IIROC Guidance Note 09-0087, which provides further guidance on best practices for product due diligence,” the notice says.

If a dealer determines a product is suitable for its broader clientele, it will be up to the advisor to ensure the product is suitable for specific investor situations. If the client is looking to buy and hold the product, IIROC strongly suggests that it’s most likely not a suitable investment.

“This analysis includes making reasonable efforts to obtain information concerning the customer’s financial situation, investment knowledge, investment objectives, risk tolerance and any other relevant customer specific information. While the customer-specific suitability analysis depends on the investor’s particular circumstances, leveraged and inverse ETFs typically are not suitable for retail investors who plan to hold them for more than one trading session, particularly in volatile markets,” IIROC writes.

IIROC is also urging dealer members to ensure that all client communication material about inverse ETFs clearly outline the risks associated with the daily resets apart from the prospectus of these products — which does outline these risks.

“For example, statements about a leveraged or inverse ETF that are designed to achieve its investment objective on a daily basis may not omit that fact or imply that the fund is designed to track the underlying index or benchmark over a longer period of time. Dealer Members are further reminded that providing risk disclosure in a prospectus or product description does not cure otherwise deficient disclosure in sales material, even if the sales material is accompanied or preceded by the prospectus or product description,” the notice says.

Howard Atkinson, president of BetaPro Management, issued a statement to various media outlets following the IIROC announcement, saying that while he agreed that all investments must be carefully scrutinized before being added to the portfolio, the SRO had perhaps been unfair in singling out leveraged ETFs.

“Horizons BetaPro double ETFs can be suitable for investors who wish to hold the ETF for longer than one trading session, as a key determinant of investment returns is market path, regardless of the holding period,” he said in the statement. “If an investor owned a Bear+ ETF and the market fell for five straight days or trended down for five straight months, they would want to hold the ETF during these periods.”

He pointed out that his firm has been proactive in “educating both advisors and investors about the performance dynamics” of the products.

(06/12/09)