Monday, December 9, 2013

FINRA Action Against JP Turner for Unsuitable Leveraged ETF Sales

By Tim Dulaney, PhD, FRM and Tim Husson, PhD

Last Thursday, FINRA ordered (PDF) JP Turner, an Atlanta-based broker-dealer, to pay restitution related to sales of leveraged and inverse exchange-traded funds (ETFs) and excessive mutual fund switching.  The total restitution to 84 customers totaled over $700,000.

Leveraged and inverse ETFs are extremely complex investments, that are designed for professional traders and are generally considered unsuitable for buy-and-hold investors.  One fundamental issue with leveraged and inverse ETFs is that they must 'rebalance' their exposure each day, which can lead to substantial deviation from the returns investors might expect.  We have discussed leveraged and inverse ETFs many times before, including about FINRA's Investor Alert.  We also have an introduction to leveraged ETFs, in addition to several research papers on the subject.

FINRA's news release noted that one deficiency in JP Turner's policies was that it "supervised leveraged and inverse ETFs in the same manner that it supervised traditional ETFs."  We certainly agree that leveraged and inverse ETFs are markedly different investments than traditional, index-linked ETFs, and we applaud FINRA for enforcing that difference as it pertains to supervision.

We haven't discussed mutual fund switching as much on this blog, but it is an important issue.  Often, there exist many mutual funds that have similar underlying exposure; for example, there are a number of mutual funds that track large-cap US equities.  Sometimes, unscrupulous brokers will trade in and out of these funds, giving investors the appearance of similar portfolio exposure but increasing transaction fees.  Thursday's FINRA action noted:
During the relevant period, despite the presence of several red flags, J.P. Turner failed to reject any of the more than 2,800 mutual fund switches that appeared on the firm's switch exception reports. As a result, 66 customers paid commissions and sales charges of more than $500,000 in unsuitable mutual fund switches.
Switching isn't restricted to just mutual funds.  ETFs can also be effectively 'churned' in this fashion.  In addition, we have even seen portfolios of structured products with unjustifiably high turnover.

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