The Public Investors Advocate Bar Association called for the Financial Industry Regulatory Authority to strengthen rules on selling complex products and options—a category that could include leveraged or inverse ETFs, options strategies used by advisors and perhaps even target-date funds—arguing advisors often fail to understand the very things they are recommending for investors.
PIABA President Michael Edmiston made the case for tighter rules in a comment letter sent to FINRA.
The comment period closed this past Monday, and respondents included hundreds of investors, industry participants, advocacy organizations like PIABA and the Securities Industry Financial Market Association, and self-directed brokerage app companies like Robinhood. Robinhood, like many brokers, advisors and asset managers, argued new rules could revert the industry to a time when certain products were accessible only “to elite and privileged investors.”
In its request for comment, FINRA argued that complex products, “if properly understood,” could generate positive outcomes for investors, and detailed several steps the agency had taken to address them over the years, including guidance and investor-focused alerts. But with the significant rise in accounts trading in these products and options, the agency argued it had to take the step of reminding brokers of its obligations (including those under the SEC’s Reg BI).
In an interview with WealthManagement.com, Edmiston said PIABA had spoken to many clients over the years who’d followed failed strategies and products recommended by brokers who were unable themselves to understand them. As an example, Edmiston described a recent mediation involving a broker recommending leveraged ETFs, which amplify the daily returns of the underlying investments; the asset managers themselves recommend the investments are not typically to be held long term, a message that often doesn't get through to the end broker or advisor. After asking the mediator why the broker had held the ETFs for more than a day, the mediator responded that the broker had said he did not understand that wasn't the way they were supposed to be used.
“There’s obviously a training and comprehension issue on the broker/dealer side and advisory side, and there’s a training issue on the supervisory and compliance side, (checking) if the products are being handled well,” Edmiston said.
Concern over these products isn’t new territory for regulators; As far back as 2009, the SEC warned investors about the dangers of holding certain leveraged ETFs for longer than a day, and Chair Gary Gensler announced an analysis last October studying the potential risks of complex products.
Edmiston said there’d been enforcement actions disciplining brokers and advisors for the inappropriate use of ETFs, but he worried these moves weren’t enough. PIABA also said it was worried about options trading in the comment letter, including the tendency for small RIA firms to use complex options strategies executed by FINRA member firms that the advisors themselves might not understand.
“The brokerage firms disclaim any responsibility for the trading, placing that responsibility on the RIA,” the PIABA letter read. “However, investors do not understand that they are dealing with two separate entities, each of which have limited responsibilities and obligations.”
“Ultimately, it becomes a question of education and one of risk management,” he said. “Can a firm teach its sales force and supervisory force how a product works, when it should be used, and how it can be used safely for an investor?” Maybe so, but without tighter rules around implementing the investments, however, Edmiston thinks some firms will be incentivized to make the investments and pay whatever penalty they may be fined later.
But other commenters are warning FINRA about the consequences of overreach, with Dave Nadig of ETF Trends writing that the agency’s wide-ranging request for comment could mean the eventual rules would include products like target-date funds. Nadig (and other commenters) also worried FINRA might mandate a test for firms to give investors to gauge their understanding of products (FINRA’s questions in its comment request include whether firms “required customer attestations regarding knowledge and experience”). Nadig also believed FINRA was not the appropriate venue for these questions.
“I agree that some products are complex, however, modern markets are complex,” he wrote. “The role of the SEC is to determine what products are available to investors under what rules.”
Edmiston’s letter highlighted PIABA’s worries about options trading done by retail investors via self-directed platforms, but in its own comment letter, Robinhood argued that it would object to any regulation setting industry standards on criteria making certain customers eligible for options trading, such as a requirement for net worth or annual income.
“Robinhood does not believe this is appropriate for its customer base or business model; many of its customers have lower net worth and less discretionary income to invest than customers of a traditional brokerage model,” the firm wrote. “Not all firms will want to use the same approval criteria when deciding which customers should be extended credit for the purpose of trading options, and FINRA should not require them to.”
Though Edmiston believed that many brokers were operating from a lack of education in complex products, he said education alone wouldn’t solve the issue.
“Unfortunately, if there’s enough money to be made, some firms are not going to be concerned with education. They’ll be more concerned with aligning product to make the money, and get in and get out,” he said. “If they get hit with any sort of enforcement action or penalty, they’re betting the penalty will cost less than the profits they make."
