A sign for the Financial Industry Regulatory Authority (Finra) is seen outside offices in New York’s financial district
The Financial Industry Regulatory Authority has asked for feedback on sales practices for ‘complex products’ © Brendan McDermid/Reuters

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US regulators are scrutinising the sale of a range of exchange traded funds to retail investors, prompting growing concerns in the industry that they are planning a clampdown.

Finra, the Financial Industry Regulatory Authority, has asked for feedback on sales practices for “complex products” amid a surge in trading by small investors of some relatively complicated vehicles.

“The number of accounts trading in complex products and options has increased significantly in recent years,” Finra said, warning that “investors may not fully understand the attendant risks”.

These risks “may be heightened” still further at a time when retail investors are increasingly accessing these products through self-directed platforms, without the assistance of a financial professional, the regulator added.

However, there are concerns over the lack of a formal definition as to what Finra means by “complex product”.

Finra said it was “a product with features that may make it difficult for a retail investor to understand the essential characteristics of the product and its risks”.  

It gave examples such as defined-outcome ETFs (for example, buffered funds that aim to protect investors from a market sell-off); funds holding cryptocurrency futures; leveraged and inverse exchange traded products; and volatility and oil-linked ETPs.

Deborah Fuhr, founder of ETFGI, a consultancy, said Finra’s definition could include mutual funds and ETFs investing in everything from high-yield bonds and emerging markets to those based on quantitative strategies or environmental, social and governance principles.

“They’ve left it very vague, and I suspect that’s intentional,” Dave Nadig, financial futurist at ETF Trends, said in a video interview with ETFGI.

In his submission to Finra, Nadig said he was “a bit terrified” by the scope of what the regulator may regard as “complex”.

“If you chase all of the footnotes and referenced documentation, it’s not hyperbole to suggest that every fund providing anything but plain vanilla beta exposure to stocks and bonds would be included.

“Anything that’s using derivatives certainly would get caught into the mix,” Nadig added. “Even target-date funds have historically been called complicated by Finra.”

Stacy Fuller, partner at K&L Gates, a Pittsburgh-based law firm, said Finra’s definition of “complex” could even extend to closed-end funds — products so vanilla that the US Congress decided they were appropriate for retail investors as far back as 1940 — as well as “potentially any mutual fund that uses derivatives for hedging”.

Derek Horstmeyer, professor of finance at George Mason University School of Business in Virginia, said: “I think that’s a bad thing when they don’t define complexity,” pointing out that complexity and risk are not always analogous concepts.

Finra declined to comment for this story, but in its request for feedback said it was “concerned” about the risks entailed in complex products’ wider adoption.

The regulator said there were now nearly 150 defined-outcome ETFs with almost $10bn of assets, while leveraged and inverse funds “are often among the most actively traded ETPs”. Similarly, it said, trading volumes for listed options have almost doubled since 2019.  

Nadig believed Finra’s move was a “reaction to a legitimate rise of retail interest in investing”, popularised by the Reddit-driven meme stock phenomenon.

“I think that’s a great thing, but because we’ve had some meme stock hysteria and folks looking at leveraging the ability to trade by phones, I think there’s a lot of concern that retail investors aren’t getting enough education,” he added.

Finra is also vague about any restrictions on retail access it might propose.

Among the ideas it is consulting on are the implementation of “enhanced” account approval processes before an investor may trade in complex products; a requirement for an investor to complete training or a learning course, and then pass a “knowledge check” before being allowed to buy certain products; or limiting access to “high net worth” investors.

In its submission to Finra, VanEck Securities said “for over 85 years, the United States securities laws have been predicated on a disclosure-based regime [with potential risks being disclosed and investors left to make their own decisions]. [This] foreshadows a world that upends this bargain.”

“The US system is based on disclosure, as opposed to a nanny state where you are not allowed to own any of these things,” said Fuhr. “It’s a big thing when you think that retail investors have over 30 per cent of the [$7tn] assets in US ETFs.”

Nadig believed that, in moving away from the notion that disclosure can be the core of effective regulation, Finra was sending a “seminal signal . . . almost suggesting that investors can’t make good decisions on their own”.

However, Horstmeyer said the US already limited access to private equity and venture capital funds to “sophisticated” investors, due to their complexity.

As such he “did not see a problem in at least putting something of a speed bump in the way” for some other products.

“We are getting data on how much retail investors have been losing on out-of-the-money options and other complex products,” Horstmeyer added. “They have been taking a lot of excess risk and maybe some of them don’t understand. I would pump the brake on that.”

However, Nadig said that while he was a “staunch advocate for greater financial literacy”, he was “firmly against the idea that my retail broker, increasingly just an app on my smartphone, is going to be the judge and jury on which retail customer is allowed access to which products based on a test that could be as subject to bias, misinterpretation and misapplication as any other standardised test”.

“[ETFs] have driven costs down and increased access for all classes of investors, especially smaller investors and financial advisers,” Nadig added. “Any action taken by regulators should start from a principle of not breaking what isn’t broken.”

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