Friday Insider: What are the regulators doing!?

Two stories caught my eye this week with a head-scratching common theme:  what the heck are the financial regulators doing, anyway?  At the risk of incurring the wrath of my regulator overlords, let’s look at these stories…

FINRA considers crackdown on high risk brokers, unpaid arbitration awards

A bit about FINRA:  They are the regulator that oversees broker-dealers, which are the clearing organizations for all commission-based products.  If someone wants to sell stock for a commission, they do so under FINRA’s watchful eye.  FINRA is not technically part of the government, they can’t send someone to prison, but they are able to fine, suspend, and even revoke a license entirely if they feel it’s necessary.

Of course laws do apply, we’re not talking about blatant criminal activity here.  Perps who execute a Ponzi scheme are still prosecuted by the courts.  In a sense, FINRA deals with the soft underbelly of the business.  Their target is more subtlety than overt law-breaking, they have to dig into the gray areas to know if someone just made a bad mistake or is acting unethically for profit.  I sympathize, I wouldn’t want their job.  However, I was on the other end of FINRA regulations for a long time, and if you’re trying to do the right thing for your clients, their layers of rules are onerous and can make the job maddening.  That’s why I was so shocked to see this headline with the word ‘considers’ in it.

The bad actors have figured out they can make a fairly nice living lurking in those gray areas, where people with no conscience tend to thrive.  Each time they are fired, suspended, fined, etc, they just end up bouncing from firm to firm, often toting their unsuspecting clients with them.  There is always a place for someone who can sell, no matter the rap sheet, it’s not hard for them to find a spot if they flash dollars.  

This would upset anyone with integrity trying to conduct my business, you’re competing against those without moral constraints, it’s an uneven playing field.  But it should really upset you, the clients.  If you were to make suggestions to FINRA about how they could help protect you from the bad guys, I’m guessing at the top of your list would be ‘don’t let people continually get away with it?’

FINRA has an excellent resource for the public called BrokerCheck, which gives you the background of any broker, where they worked, along with their disciplinary actions, if any.  The question is, does FINRA ever look at its own system?

In February, Investment News detailed the account of one David Fagenson, “who was recently fired by UBS Financial Services Inc. only to land at an independent broker-dealer with a history of compliance problems, Newbridge Securities Corp.”

It goes on to detail Mr. Fagenson’s embarrassing career, “working at eight firms over the span of 29 years. In addition to his recent firing, the 12 additional marks or disclosure events on his BrokerCheck report are nine customer disputes, two regulators issues and a criminal matter.”  He’s either the unluckiest guy in the industry or he’s made an entire career out of conducting shady business, and when the authorities sniff him out, he simply re-brands in the next town.  Same circus, different tent.

I’ve said it before, you can’t regulate away bad people, but the common sense rule should apply here.  Where there’s smoke there’s fire, and his record sure looks a barbeque pit.  If FINRA is only just ‘considering’ going after these guys, you have to question where their priorities lie.  To their defense, they can’t prevent a company from hiring someone, but they sure can prevent someone like this from keeping their license (FINRA approved his license when he landed at Newbridge).  I know I would feel a lot better if this type of guy weren’t out there giving all of us a bad name, and I’m sure his potential clients would agree.

SEC Approves request to list quadruple-leveraged ETFs

This story doesn’t repeat the first, but it sure does rhyme.

You’ve probably heard of the SEC, they are the authority for public financial markets.  Their website states ‘The SEC strives to promote a market environment that is worthy of the public’s trust.’  It’s with that goal in mind that we open this discussion about a quadruple-levered product, approved for sale and soon to be pushed by a broker near you.

There’s a lot to unpack with the headline above, so I’ll be brief and simple.  An ETF stands for exchange-traded fund, which simply means you can buy this one investment to gain exposure to lots of other stuff that’s inside of it.  In this case, lots and lots of leverage.  The product is designed to give you 4 times the return of the S&P 500 on a daily basis.  Simple math tells you on a day that the S&P 500 goes up 1%, you will see a 4% return.  Sounds pretty cool right?

Everything, and I mean everything, about this product is bad for real investors.  There’s one scenario where it could reward people, and that’s if you could see the future.  If you wake up one day and happen to know the market is going to go up 3%, get to a screen as fast as you can (also, call me) and place an order, making sure to take your profits before market close.

For everyone else that doesn’t have a crystal ball, this investment stinks.

The math and mechanics of a leveraged daily product can be quite complicated, but suffice it to say it doesn’t add up in your favor.  The important point is these are meant to be daily products, as in, you only use them for one day.  If someone calls you and tries to sell you an ‘investment’ to use for one day, would you want to take that phone call?

To best illustrate how bad of an idea these are, I created this spreadsheet.  One investment shows you buying the S&P 500, and one shows you buying this SEC-approved disaster:

What do you notice with this simple example?  First, if the market doesn’t move in your favor immediately, things start to look ugly.  Second, there’s a really subtle issue that pops up after only 6 days…you were promised 4x the return of the S&P500, and yet you’re down more than 4x the market return of -1.11%.

No reason to be more detailed than this, if you extrapolate the returns over months and years they only look worse.  Want some real world examples of these products destroying portfolios?

Here’s a comparison of the 20-year treasury bond (red line) vs its 3x buddy (blue line):

Treasuries are down -2.56% over the past year, while your 3-times upside ETF is down -18.57% over the same time period.

Or this hilarious comparison captured by Charlie Bilello over at Pension Partners – this is the gold mining index (red line) vs. its leveraged counterparts (white and green):

You only have to investigate these products for about, oh, 500 words to know they have no appropriate place in a person’s portfolio, or worse, being sold to people as some sort of solution.  FINRA and the SEC have many functions, but their main role is to protect you and your dollars from nefarious activity.  With these two headlines, I ask again, what the heck are they doing?

Editor’s Note:  As of this posting, word came that the SEC was ‘reconsidering’ its approval of these products, let’s hope sanity prevails.

Disclaimer: All written content on this site is for information purposes only. Opinions are solely those of Innovate Wealth unless otherwise specified. Material presented is believed to be from reliable sources and no representations are made by our firm as to another parties’ informational accuracy or completeness. All information or ideas provided should be discussed in detail with an advisor, accountant or legal counsel prior to implementation.  

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