Progress has been made in improving disclosure and education on leveraged derivative exchange-traded funds, but much remains to be done, according to a new report from the Canadian Foundation for Advancement of Investor Rights.

The report discusses positive steps that have been taken to protect investors in leveraged and inverse ETFs. It follows a report released by the same organization in mid-May, which argued that leveraged and inverse ETFs endanger the health of investment portfolios if held for periods longer than a few days. In the initial report, FAIR Canada called for regulatory action to require more prominent disclosure of the risks involved with the products.

According to the latest report, progress made on the issue includes action taken by the Investment Industry Regulatory Organization of Canada (IIROC) and the Financial Industry Regulatory Authority (FINRA) in the United States, which have issued notices to members, alerting them to the potential dangers of investing in these products, and reminding members of their due diligence and suitability obligations to their customers in trading leveraged and inverse ETFs.

In addition, the report acknowledges that the issue has been covered extensively by the financial press as well as Morningstar and other financial industry observers, which has helped educate the industry, regulators and retail investors about the products.

Prospectus disclosure is also improving in both Canada and the U.S., according to the report.

“These initial changes are encouraging, but much remains to be done to protect retail investors from the risks posed by leveraged, inverse and commodity ETFs,” said FAIR Canada executive director Ermanno Pascutto. “On the surface they look like plain vanilla ETFs, but they have very different holdings, returns and risks.”

Pascutto argues that advertising for the ETFs is based on incorrect inferences as to the correlation of the products to their underlying index or commodity.

Howard Atkinson, president of BetaPro Management Inc. – the only provider of leveraged ETFs based in Canada – said the company has always provided sufficient disclosure on how its products work.

“We work with the regulators to provide adequate disclosure,” said Atkinson. “Our disclosure has evolved to reflect the different types of products that we have launched.”

He agrees that educating investors is crucial.

“The points made in this report, which were very similar to the first report, are in some cases educational points that we’ve been making since we launched our products in 2005,” Atkinson said. “We remain dedicated to education, delivering seminars across Canada to our clients and regularly working with media to explain how our products work and what investment objectives they satisfy.”

But FAIR Canada calls for the Canadian securities regulators to take steps to further protect individual investors.

Specifically, the organization calls for improved prospectus disclosure that includes warnings in plain language that these are day trading products for sophisticated investors and that they do not deliver their promised performance for longer than a day.

In addition, FAIR Canada urges the regulators to implement risk disclosure and acknowledgment requirements for any retail investor who wishes to trade these products, similar to requirements for trading derivatives such as options and futures contracts.

It also calls for specific guidance on advertising of the products, and the requirement that the leveraged derivative ETFs have a different name to distinguish them from plain vanilla ETFs. FAIR Canada suggests calling them Listed Derivative Products, or LDPs.

The association also urges the Canadian Securities Administrators (CSA) to work with IIROC and the industry to undertake research into all of the issues posed by leveraged, inverse and commodity ETFs,

“This is not a small problem,” said FAIR Canada associate director Steve Garmaise. “Urgent action to protect retail investors is needed.”

BetaPro report aims to eliminate confusion over leveraged ETFs

As part of BetaPro’s efforts to educate investors, the company has commissioned a report discussing the use of leveraged ETFs compared to using leverage in a margin account.

“The research conducted is a thorough, in-depth analysis on leveraged ETFs that should help dispel any concerns about how they work,” said Atkinson.

The report, entitled “Understanding the Returns of Leveraged Exchange Traded Funds,” reviews the effects of compounding and rebalancing if an investor were to hold these funds over longer periods.

The report concludes that the direction, or market path, of an index is a key factor in how leveraged ETFs perform for investment periods longer than one day. The amount of volatility in a market will determine if these funds diverge, positively or negatively, from two times their underlying index over any given holding period, according to the report.

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