On February 14, 2017, the Securities and Exchange Commission (“SEC”) instituted administrative and cease-and-desist proceedings pursuant to sections 203(e) and 203(k) of the Investment Advisors Act of 1940 (the “Order”), alleging that Morgan Stanley was responsible for the unsuitable solicitation and sale of inverse ETFs to clients. Morgan Stanley has submitted a settlement Offer of $8 million (the “Offer”), and acknowledged wrongdoing in selling and marketing these inverse ETFs as a long-term investment strategy, when Morgan Stanley’s very own compliance policy procedures recommended such ETFs for only short term holds.
An ETF is a fund which owns underlying assets in a given sector (shares of a stock, bonds, foreign currency) and divides ownership of these assets into shares, which can be purchased by investors. Investors do not have any direct claim to the underlying investments, but indirectly own them through the ETF shares. ETFs can be sector specific (aerospace defense, semiconductors, uranium) or broad and track overall market performance. According to the Order, the specific type of ETF Morgan Stanley was improperly selling to investors is an “inverse” ETF. Nontraditional ETFs are generally inverse, leveraged, or inverse leveraged, although other more exotic types of ETFs such as different bundling’s of derivative options exist. Inverse ETFs track an underlying package of securities; however, they are composed of various option derivatives that sell the underlying asset short. This means that if the underlying assets go up, the inverse ETF goes down, and if the underlying assets go down in value, the inverse ETF rises in value.
Pursuant to FINRA Regulatory Notice 09-31, inverse ETFs are not suitable for long term holds for two reasons. First, the most the ETF can appreciate is 100%, if all its underlying assets go to zero (highly improbable), whereas a long ETF can appreciate as much as its assets rise which could over the course of several decades lead to a doubling or tripling of your initial investment. The second and most significant reason for why inverse ETFs are dangerous for a long-term hold, is that there is an underlying cost to hold them both in higher fees, and in inherent structural costs called “beta-slippage decay.” The high fees associated with inverse ETFs, generally 1%, are due to the costs associated with purchasing “shorts,” or option derivatives on the underlying assets. This makes inverse ETFs more expensive than regular ETFs, which simply purchase underlying assets rather than short options. Beta-slippage decay is a mathematical term used to describe the costs associated with rebalancing on inverse or leveraged ETF. In summary, if the underlying assets that the inverse ETF is pegged to do not change in valuation, the inverse ETF will slowly decline in value due to fees and rebalancing costs. This is why inverse ETFs are unsuitable for long term holding strategies, unless in rare cases they are part of a specific, documented hedging strategy where benefits outweigh these increased costs.