In November 2020, the SEC settled actions against five advisory firms for violations related to unsuitable sales of complex exchanged-traded products (ETPs). According to the settlement agreements, customers lost significant portions of their investments after the firms’ registered representatives recommend that investors hold short-term investment products for far longer than they should have. So far, the firms have agreed to return a total of $3 million to their investors.

This latest action is a perfect example of why complex ETPs should not be on offer to the average investor. There are very few checks in place to prevent investors from purchasing complex securities at the behest of their financial adviser, when neither the investor nor the adviser fully understands the investment strategy. Most importantly, financial advisers should make sure that investors understand the financial risks associated with any financial product on offer. Investment advisers are fiduciaries and therefore required to inform their clients of risks, and brokers are required to consider their client’s financial situation when recommending a security. In this case, the SEC took aim at the firms, who have a duty to supervise their registered representatives to ensure they are making suitable investments according to the Financial Industry Regulatory Authority’s (FINRA’s) guidelines.

What is a Complex Exchange-Traded Product?

Exchange-Traded Products (or ETPs) are a type of investment that bundles stocks, bonds, or other financial instruments. These financial instruments might comprise funds, promissory notes, or trusts. If the ETP’s underlying investments perform well, so does the ETP. And if the underlying investments lose money? Unfortunately, these types of investments come with significant risk, and losses for investors can be devastating.

ETPs trade on stock exchanges, and anyone can buy them, just as they would common stocks. According to The Wall Street Journal, however, complex products are best left to experienced investors – especially in the case of complex ETPs.  Stephanie Avakian, the Director of the SEC’s Division of Enforcement, said the following in a statement: “It is important for firms to put the appropriate protections in place to ensure complex products are properly evaluated and understood by their representatives. Failing to do so puts investors at risk.”

How Does an Exchange-Traded Product Make Money?

ETPs may attempt to realize profits using several methods. Many of these methods, like leveraged funds and inverse funds, are considered complex trading strategies. They often involve a gamble based on a financial adviser’s (possibly unfounded) belief about how they market will behave.

Exchange-Traded Notes: Exchange traded notes (ETNs) are unsecured debt obligations issued by financial institutions. They typically take at least 10 years to mature. Instead of paying interest, they pay an agreed-upon sum based on the performance of the underlying index, minus fees. The value of the ETN depends on the credit of the issuer, which could be downgraded before the maturity date, potentially resulting in losses for the investor. Redeeming ETNs before their maturity date is also risky and can easily result in a loss.

Leveraged Funds: These investments rely on complicated strategies, like options, swaps, and futures to multiply the return on an investment. An option, for instance, is a contract to buy a security at a certain price by a specified date. With an option, a broker is essentially betting money that they know how the market will behave, which is always a risky gamble.

Inverse Funds: Inverse funds seek to make money on a drop in the price of a security. Many of these funds use leverage, similarly to the options example mentioned above.

Volatility-Linked Products: These types of financial products attempt to make money based on sharp price changes in the market. 

Why Do Investors Sign Up for Exchange Traded Products?

ETPS work similarly to mutual funds – they track a particular group of securities and mirror their successes – but they don’t come with the hefty fees often associated with mutual funds. But is anything really free? As financial regulation specialist James Fanto told The Wall Street Journal, “In the discount world, it’s your own obligation [to research financial advisers and financial products].” Investors should ask themselves: “Is it more likely that I will save money by purchasing an ETP, or is it more likely that I will suffer substantial losses? The recent SEC action should serve as a cautionary tale.

What Led the SEC to Take Action?

The SEC’s Division of Enforcement Complex Financial Instrument Unit used trading data to uncover unsuitable sales of exchange-traded products. In the November 2020 action, the SEC noted that the description of the products explicitly stated that the ETPs should be traded over the short term. They were volatility-linked products and designed for short-term trading. But certain registered representatives recommended that the investors hold on to these financial instruments for much longer than would have been ideal, revealing that they may not have understood the securities that they were selling.

What Can I Do If I Lost Money Investing in Complex Exchange-Traded Products?

If your broker or investment adviser misrepresented the risks of an ETP, you can attempt to recover losses. Contact the securities attorneys at Fitapelli Kurta for a free case assessment: (877) 238-4175 or info@fkesq.com.

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