In the Wrong

​Admissions of wrongdoing are rare in securities enforcement cases.

Comments Views

​Morgan Stanley has admitted to selling clients a risky product without disclosing that it was likely to lose money and has agreed to pay the U.S. Securities and Exchange Commission (SEC) US$8 ​million to settle the case, Fortune magazine reports. According to the SEC, Morgan Stanley's wealth management division marketed single inverse exchange traded funds (ETFs) in retirement and other accounts to several hundred clients between 2010 and 2015. This type of fund is typically used as a hedge against fallin​g prices because it profits when its benchmark price decreases. As such, it is not used as a long-term investment, as the firm acknowledged it had marketed the product. This is a rare case in which an investment firm has admitted to wrongdoing in an SEC enforcement case, Fortune notes.

Lessons Learned

At least part of the root source of this story can be traced back to the 2008 world financial crisis. ETFs have been available as investment instruments in the U.S. since the early 1990s (earlier in Canada), and have become increasingly attractive to investors. As of December 2014, more than US$2 trillion was invested in various forms of ETFs in the U.S. alone. Inverse ETFs rapidly became more popular as a strategy to cope with high market volatility. And, even though many inverse ETFs carry expense ratios of 1 percent or more or use daily futures contracts to produce their returns — in which f​requent trading often increases fund expenses — they appeal to investors as easier and less costly than short selling stocks, which require a margin account and stock loan fees paid to a broker for borrowing the shares necessary to sell short. These inverse ETFs are nonetheless likely to be as risky as short-selling, particularly where an investor can be misled into holding on to them for too long, as Morgan Stanley admits to doing. In 2008, the SEC changed the rules for creating inverse ETFs, expanding the definition from an index basis only to include actively managed groups of funds. The latter category can increase risks significantly, both as a result of the discretion given to fund managers and because their investment strategy may become discernible to others.

Both the SEC and the investment industry would be well-advised to review their rules and procedures governing the use of high-risk, short-term investment instruments such as inverse ETFs (and leveraged ETFs). Automatic cut-offs of inverse ETF agreements after a maximum of 30 days — or a similar short, specified time limit — could help. Greater requirements and monitoring on the part of investment companies to actively disclose the strengths, weaknesses, and risks of such investment vehicles is another mitigating strategy against fraud. At a minimum, that disclosure should include:

  • A leveraged and inverse ETF advertised as having three times the gain could also have three times the loss.
  • Pricing is adjusted every day at close of market so that price swings can be excessive.
  • The high risk of holding leveraged and inverse ETFs for longer periods of time make them unsuitable for long-term investors.

Of course, investors themselves should be better educated about these risks. In general, ETFs can convey a false sense of stability in profit-making, given their structure being based on an underlying group of stocks or other investment forms. The U.S. Financial Industry Regulatory Authority's (FINRA's) view is that inverse and leveraged ETFs are unsuitable for retail customers. FINRA also has stated that the added complexity of leveraged and inverse exchange-traded products makes it essential that brokerage firms have an adequate understanding of the products and sufficiently train their sales forces before the products are offered to retail customers. An educated investor should ask his or her advisor or broker about this. Also, if an advisor or broker recommended the purchase of leveraged and inverse ETFs without fully conveying their risks and the investor lost money, the investor may want to discuss his or her legal rights to a recovery with a law firm.

Finally, internal audit units within the investment industry should include these kinds of higher risk investment vehicles as part of their fraud risk assessments and audit plans. Moreover, they should ensure that the results of their ensuing audit work, including recommendations, are heard by senior management.​


Art Stewart
Internal Auditor is pleased to provide you an opportunity to share your thoughts about the articles posted on this site. Some comments may be reprinted elsewhere, online or offline. We encourage lively, open discussion and only ask that you refrain from personal comments and remarks that are off topic. Internal Auditor reserves the right to remove comments.

About the Author

 

 

Art StewartArt Stewart<p>​Art Stewart is an independent management consultant with more than 35 years of experience in internal audit, financial management, performance measurement, governance, and strategic policy planning.​​​</p>https://iaonline.theiia.org/authors/Pages/Art-Stewart.aspx

 

Comment on this article

comments powered by Disqus
  • MNP_Nov 2017_Prem 1
  • IIA Bookstore_Nov 2017_Prem 2
  • IIA EndOfYear CPE_Nov2017_Prem 3