Regulatory Compliance in Leveraged ETF Sales Practices

The Wall Street Journal reported last week that “Popular Leveraged Funds Shock Investors With Huge Losses.”  It is important to understand how to offer such instruments consistent with regulatory expectations.

What Is a Leveraged ETF?

Leveraged ETFs are funds that use derivatives or internal borrowing to magnify the daily performance of an underlying asset, such as a stock or index.  Their popularity increased with the approval of leveraged single-stock ETFs in 2022 as retail investors seek outsized gains during market rallies.  However, their daily reset mechanism and compounding effects make them highly volatile and unsuitable for most long-term holding strategies.

Over time, volatility can cause leveraged ETFs to diverge significantly from the performance of their underlying assets - a phenomenon known as volatility decay.  For example, if a stock drops 30% and rebounds 50%, it ends up 5% higher.  But a 2x leveraged ETF tracking that stock would fall 60% and rise 100%, ending with a 20% loss.  This example illustrates how compounding daily returns can amplify long-term losses, even when the base asset recovers.  While some investors have suffered steep losses due to misunderstanding these dynamics, others, like certain hedge fund managers, have profited by shorting them, calling them “destined to fail.”

Structurally, leveraged ETFs avoid traditional margin rules because they are regulated as investment companies under the Investment Company Act of 1940.  This allows them to use internal leverage through derivatives rather than broker-provided margin, thereby avoiding restrictions on leverage imposed by the margin rules.  Though they can be purchased in margin accounts, the leverage is embedded in the fund itself, which permits overall leverage that would not be permitted under the margin rules.

Compliance Under FINRA and SEC Rules

Given their complexity and risk profile, advisors and broker-dealers face strict regulatory obligations when recommending leveraged and inverse ETFs.  Under FINRA Rule 2111, firms must meet three suitability standards:

• Reasonable-Basis Suitability - Advisors must understand the product’s risks and rewards and determine whether the product is suitable for at least some investors.
• Customer-Specific Suitability - Recommendations must align with the individual investor’s profile, including age, financial situation, and risk tolerance.
• Quantitative Suitability - Advisors must ensure that a series of transactions is not excessive or unsuitable when viewed collectively.

These standards are reinforced by SEC fiduciary rules, which require both broker-dealers and investment advisers to recommend investments that are suitable for their clients  and to maintain robust compliance systems relating to their fiduciary obligations.  Leveraged ETFs are designed for short-term trading, not long-term holding, and firms must ensure both advisors and clients understand this distinction.

Enforcement Actions and Lessons Learned

The SEC’s May 4, 2023 settled action against Classic Asset Management illustrates the risks of noncompliance.  According to the SEC order, the firm invested client assets in leveraged ETFs for months or years without understanding their structure or monitoring them properly, resulting in alleged violations of Sections 206(2) and 206(4) of the Investment Advisers Act, which prohibit deceptive practices and require written compliance procedures. 

Similarly, FINRA’s May 18, 2020 enforcement against SunTrust Investment Services revealed failures in supervision and training.  From 2015 to 2018, SunTrust allowed representatives to recommend non-traditional ETFs without ensuring they understood the risks or had systems to monitor holding periods.  According to the FINRA AWC, the firm lacked alerts for extended duration holdings and did not require customer-specific suitability reviews for positions held longer than a day. These failures allegedly violated FINRA Rules 3110(a), 3110(b), and 2010, resulting in over $584,000 in customer losses, which SunTrust ultimately reimbursed.

Implementing Effective Compliance Measures

To meet regulatory expectations and protect investors, firms must adopt rigorous supervisory systems tailored to the unique risks of leveraged ETFs.  These products are not suitable for buy-and-hold strategies, and firms should implement alerts or exception reports to monitor holding periods, require customer-specific suitability reviews for extended positions, and ensure sales personnel receive targeted training on product mechanics and risks. Written supervisory procedures (WSPs) must clearly outline how leveraged ETFs should be recommended, monitored, and reviewed, reinforcing a culture of compliance and investor protection.