Table of Contents
SERIES 7 | SERIES 65 | FINANCIAL REGULATION COURSES
FINRA Regulatory Notice 09-31 — Non-Traditional ETFs: FINRA Reminds Firms of Sales Practice Obligations Relating to Leveraged and Inverse Exchange-Traded Funds — issued in June 2009, is one of the most consequential and most directly enforcement-referenced regulatory guidance documents in the history of FINRA's investor protection programme, establishing the foundational regulatory position that inverse and leveraged exchange-traded funds that reset daily are typically unsuitable for retail investors who plan to hold them for longer than one trading session — particularly in volatile markets — and reminding member firms of their obligations under FINRA Rule 2111 to conduct thorough reasonable-basis and customer-specific suitability analyses before recommending these highly complex products to any customer.
The notice was issued in response to the rapid growth of the non-traditional ETF market and the mounting evidence that retail investors — and in some cases the registered representatives recommending these products — did not fully understand the fundamental structural characteristic that makes leveraged and inverse ETFs so different from conventional investment products: the daily reset mechanism and its compounding consequences that can cause the fund's performance over periods longer than a single trading session to diverge dramatically and unpredictably from the stated investment objective, sometimes producing large losses even when the investor correctly anticipated the direction of the underlying index.
Regulatory Notice 09-31 remains the primary FINRA guidance document governing the sale of leveraged and inverse ETFs — it has been cited in virtually every FINRA enforcement action involving these products since its issuance, it has been referenced extensively in FINRA arbitration proceedings involving investor claims against broker-dealers for unsuitable leveraged and inverse ETF recommendations, and it has established the standard of care against which the conduct of registered representatives recommending these products is assessed.
To understand the investor protection concern that Regulatory Notice 09-31 addresses it is essential to understand what leveraged and inverse ETFs are and how they differ from conventional exchange-traded funds.
A conventional exchange-traded fund is a registered investment company that holds a portfolio of securities — typically designed to track a specific market index — and whose shares trade on a national securities exchange throughout the trading day at market-determined prices. The conventional ETF's performance over any period closely tracks the performance of its underlying index over the same period — a fund tracking the S&P 500 that rises five percent in a month reflects the approximate five percent gain of the index over that month, with minor differences attributable to fees and tracking error.
A leveraged ETF is designed to deliver a multiple of the daily return of its underlying index — typically two times or three times the daily return. A two-times leveraged ETF tracking the S&P 500 aims to deliver two percent on days when the index rises one percent, and to lose two percent on days when the index falls one percent.
An inverse ETF is designed to deliver the opposite of the daily return of its underlying index — typically negative one times, negative two times, or negative three times. An inverse ETF tracking the S&P 500 aims to gain one percent on days when the index falls one percent — providing a vehicle for investors seeking to profit from or hedge against declining markets without selling the index short.
Both leveraged and inverse ETFs achieve their daily objectives through the use of derivatives — including futures contracts, swap agreements, and options — that reset the fund's exposure at the end of each trading day to restore the target leverage or inverse ratio for the following day. This daily reset mechanism is the structural feature that creates the compounding consequences that make these products inappropriate for most retail investors as intermediate or long-term holdings.
The daily reset mechanism of leveraged and inverse ETFs creates a mathematical phenomenon — often called volatility decay or beta slippage — through which the fund's cumulative return over periods longer than one trading session can diverge dramatically from what a naive investor would expect based on the fund's stated daily objective and the movement of the underlying index over the same period.
The compounding effect of daily returns — both gains and losses — means that a leveraged or inverse ETF held for multiple days does not simply deliver a multiple or inverse of the underlying index's return over that period. Instead the daily percentage changes compound in ways that systematically disadvantage longer-term holders — particularly in volatile markets where the index experiences significant up and down movements even if it ends the period near where it started.
The example cited in Regulatory Notice 09-31 illustrates the magnitude of this divergence vividly. Between December 2008 and April 2009 the Russell 1000 Financial Services Index gained approximately eight percent. During the same period a three-times leveraged ETF tracking this index fell fifty-three percent — and a three-times inverse ETF tracking the same index declined by ninety percent. Both outcomes would seem impossible to investors who assumed that the leveraged ETF would gain approximately twenty-four percent — three times the index's eight percent gain — and that the inverse ETF would lose approximately twenty-four percent — three times the index's eight percent gain would produce a three-times inverse loss of that amount. The reality — catastrophic losses in both the leveraged and inverse funds despite the index's positive return — illustrates the power of compounding and daily reset to produce outcomes that are radically different from investor expectations.
Regulatory Notice 09-31 identifies three specific obligations that the existing regulatory framework — particularly FINRA Rule 2111 suitability and FINRA Rule 2210 communications standards — imposes on member firms in connection with the sale of leveraged and inverse ETFs.
The first obligation is the suitability obligation — recommendations to customers must be suitable and based on a full understanding of the terms and features of the product recommended. This requirement has two distinct components that the notice treats separately. The reasonable-basis suitability component requires that the registered representative recommending the product actually understand how it works — including the daily reset mechanism and its compounding consequences — before making any recommendation. A registered representative who does not personally understand why a three-times leveraged ETF held for six months may not deliver three times the index's six-month return has not satisfied the reasonable-basis suitability obligation regardless of any other consideration. The customer-specific suitability component then requires that the recommendation be appropriate for the specific customer's investment profile — recognising that even among the limited category of customers for whom these products might be appropriate, not all such customers will have the risk tolerance, investment sophistication, and active monitoring capability required.
The second obligation is the communications standard — sales materials related to leveraged and inverse ETFs must be fair and accurate. The daily reset mechanism and its compounding consequences must be disclosed clearly and prominently in any marketing materials used to promote these products — not buried in footnotes or obscured by performance presentations that misleadingly suggest the fund's multi-period performance will mirror a multiple of the index's performance over the same period.
The third obligation is the supervisory obligation — firms must have adequate supervisory procedures in place to ensure that these obligations are met. The written supervisory procedures required by FINRA Rule 3110 must specifically address the suitability analysis required before any recommendation of a leveraged or inverse ETF, the training required to ensure registered representatives understand these products before recommending them, and the monitoring of customer account positions in these products to identify situations where holding periods have extended beyond the single-session design horizon.
Regulatory Notice 09-31 specifies minimum elements that firms' written supervisory procedures must include if the firm promotes or allows its registered representatives to recommend leveraged and inverse ETFs.
The procedures must require that an appropriate reasonable-basis suitability analysis be completed before any recommendation — specifically that the registered representative conducting the analysis actually understand the daily reset mechanism and compounding consequences before concluding that the recommendation has a reasonable basis for at least some investors.
The procedures must require that associated persons perform appropriate customer-specific suitability analysis — assessing whether the specific customer's investment profile including their investment objectives, risk tolerance, time horizon, investment experience, and financial situation makes the recommended product appropriate for them given its daily reset design and the risk of significant loss from extended holding in volatile markets.
The procedures must ensure that all promotional materials are accurate and balanced — not presenting leveraged or inverse ETF performance in ways that create a misleading impression of how the products perform over holding periods longer than one trading session.
The procedures must require that associated persons receive adequate training regarding the terms, features, and risks of leveraged and inverse ETFs before recommending them to customers — recognising that the daily reset mechanism and its compounding consequences are not intuitively obvious and that adequate training is a prerequisite for the product understanding required by the reasonable-basis suitability obligation.
Regulatory Notice 09-31 has been cited in virtually every FINRA enforcement action involving leveraged and inverse ETF sales practice violations since its issuance — establishing the notice's guidance as the standard of care against which registered representative conduct in this product area is assessed.
In 2012 FINRA ordered four major broker-dealers — Citigroup Global Markets, Morgan Stanley Smith Barney, UBS Financial Services, and Wells Fargo Advisors — to pay a combined total of approximately nine-point-one million dollars in fines and restitution for supervisory failures in connection with the sale of leveraged and inverse ETFs. The enforcement actions found that each firm had failed to establish adequate supervisory systems for the sale of these products despite the clear guidance of Regulatory Notice 09-31 — allowing registered representatives to recommend leveraged and inverse ETFs to retail customers without the product knowledge training required by the notice and without adequate monitoring of customer holding periods.
The pattern of enforcement actions following Regulatory Notice 09-31 demonstrates that FINRA treats the notice's guidance as establishing mandatory standards — not merely aspirational best practices — for the sale of leveraged and inverse ETFs. Member firms that allow registered representatives to recommend these products without the supervisory infrastructure specified in the notice face significant enforcement risk regardless of whether any specific customer suffered demonstrable losses.
Regulatory Notice 09-31 connects directly to several other areas of the FINRA regulatory framework that are tested across the Series 7 and Series 65 examinations.
The notice applies the suitability framework of FINRA Rule 2111 to a specific category of complex product — demonstrating how the three components of suitability analysis operate in a real-world product context and what the reasonable-basis component requires when the product has technical characteristics that are not intuitive. The inverse ETF and leveraged ETF concepts addressed in the notice connect to the Inverse ETF and Leveraged ETF entries of this dictionary — which address the product characteristics and investment risks of these instruments in detail. The notice's communications standards connect to FINRA Rule 2210's requirements for fair and balanced retail communications — demonstrating the specific application of those standards to complex product marketing.
FINRA Regulatory Notice 09-31 is tested on the Series 7 and Series 65 examinations in the context of complex product suitability, leveraged and inverse ETFs, the daily reset mechanism, and the supervisory obligations applicable to the sale of non-traditional investment products.
The key points to retain are these.
FINRA Regulatory Notice 09-31 — issued June 2009 — established the regulatory position that inverse and leveraged ETFs that reset daily are typically unsuitable for retail investors who plan to hold them for longer than one trading session — particularly in volatile markets — because the daily reset mechanism and the compounding of daily returns causes multi-period performance to diverge dramatically and unpredictably from what investors expect based on the fund's stated daily objective and the performance of the underlying index over the same period.
The notice reminds firms of three obligations — the suitability obligation requiring reasonable-basis analysis demonstrating actual product understanding and customer-specific analysis of the specific investor's profile, the communications standard requiring fair and accurate disclosure of the daily reset mechanism and compounding consequences, and the supervisory obligation requiring written supervisory procedures addressing product knowledge training, suitability analysis documentation, and monitoring of customer holding periods.
The example from December 2008 to April 2009 — in which a three-times leveraged ETF fell fifty-three percent and a three-times inverse ETF fell ninety percent while the underlying Russell 1000 Financial Services Index gained approximately eight percent — demonstrates the magnitude of compounding divergence that can occur in volatile markets and is the most frequently cited illustration of the daily reset risk in both regulatory guidance and enforcement actions.
