LETFs: The Trojan Horse to the everyday Investor  

Jerome Lussan in collaboration with Charlotte Hide

Mis-selling of ETFs is damaging and illegal, but the mis-selling of Leveraged ETFs (LTEFs) has the potential to be far more catastrophic. LETFs can be dangerously easy to mis-sell because it feels like it can be promoted to retail clients. Still, there is little in terms of retail-friendly information available considering its complexity.

Firstly, what is a Leveraged ETF and how is it different to a regular one?

An Exchange-Traded Fund (ETF) is a portfolio of stocks ‘that contains a basket of securities from the index that it tracks’. An example of this is how if an ETF tracks the FTSE 100, it ‘will contain the 100 stocks in the index’ – if the ‘index moves up or down, the ETF mimics its performance as closely as possible’.[1]

A Leveraged Exchange-Traded Fund (LETF) on the other hand, is a portfolio of cash and derivatives that attempts to match the desired return.

The three types of LETF are the following:

1. Leveraged Index ETFs
2. Single-Stock Leveraged ETFs
3. Inverse Leveraged ETFs

LETFs were first allowed by the Securities and Exchange Commission (SEC) in 2006[2] for ‘day-to-day trading’ to create short-term gains but have instead proven to be more ‘unpredictable’ than regular ETFs over longer periods, and ‘can significantly compound losses’.[3] Therefore, their ‘daily return’ can be ‘twice or three times the daily return of the underlying security’, but whilst winnings can be significantly higher losses can also be significantly worse.[4]

Why are LETFs so much riskier that ETFs?

We already know that LETFs are significantly more risky than regular ETFs, but they are also far more complex to navigate. Whilst they ‘provide returns as if the investor had borrowed, they instead use complex instruments such as equity swaps […] to replicate the return of what is being invested multiplied by a target amount’.[5] Therefore, it appears to the everyman investor as a simple and ‘highly appealing proposition’ – why not choose to buy this also low-cost[i] ETF that claims to triple their return?

However, as with all leveraged instruments, losses have the potential to be devastating. This is the key factor that often gets lost in translation when investors try to make sense of the advantages and disadvantages of an LETF compared to a regular ETF.

Put in simple terms, the risk versus reward factor of an LETF is wildly imbalanced, both in the short and long term.

So how does mis-selling fit into all of this?

The key issue is that LETFs are accessible to anyone, whilst the information necessary to make an informed decision about these investments is not. The information available online is probably not digestible to the average investor who is just looking to make some passive income.

Terry Smith, founder of Fundsmith, published an article for Investment Week that detailed his certainty that both ETFs and LETFs were bound to be ‘the next miss-selling scandal’.[8] Smith wrote that he suspects ‘a lot of retail investors think ETFs are the same as index funds’ when most are not, indicating a lack of transparency surrounding even regular ETFs. However, a misunderstanding or lack of transparency surrounding ETFs will automatically translate into a lack of understanding surrounding LETFs, which could have much more dire consequences.

To conclude, there is simply not enough information digestible to retail investors to justify how easily those same investors can choose to invest in LETFs. Not only is this information not around, but when it is it may be deemed misleading because it is suggesting to investors that they are investing in a product that they recognise and understand.

This is what could directly cause the slip into mis-selling.

So, what are the consequences if UK firms are found guilty of mis-selling complex investments like LETFS?

Employees of the New Economic Foundation Lydia Prieg and Tony Greenham pointed out as early on as 2012 that it is simply ‘irresponsible and inappropriate to sell complicated products to the general public’ as they are ‘highly unlikely to ever fully understand them’. Not only are LETFs much riskier than they might appear, but now ‘many [regular] ETFs now lend investors’ assets out to banks and other financial institutions’, therefore fund managers may be getting their hands on ‘the lion’s share’ of returns, despite investors being the ones who ‘shoulder the risks’.[10]

Regulators have globally ‘already issued warning about ETFs’ following the ‘aftermath of the rogue ETF trader at UBS’.[11] This scandal revolved around the unauthorised trading performed by a director of the bank’s Global Synthetic Equities Trading team in September 2011. Therefore, not only should selling ETF’s be handled with care but selling LETFs which are more volatile should be done far more tentatively.

The consequences of mis-selling complex investments such as LETFs can range from a warning to being fined heavily by the Financial Conduct Authority. Culprits fined for mis-selling investment products over the past two decades include big names like Barclays, who were ordered by the FCA to reimburse £70 million to customers who were mis-sold investments they believed to be more reliable than in reality, as well as paying a £7.7 million fine.[12] Another example is the incident of Stonebridge International Insurance being fined £8.4 million by the FCA for ‘mis-selling accident insurance products’ – this was because the ‘telesales scripts that Stonebridge designed […] did not provide clear, fair and balanced information.’[13] Both examples of the relevant information were deemed to be misleading enough to be classified as mis-selling mostly due to lack of transparency and lack of information.

The FCA has defined mis-selling as ‘a failure to deliver fair outcomes for consumers’, which seems to be a relatively high risk when considering the distribution to retail investors of LETFs.[14]

How can you avoid falling foul of these same fines?

A good example of how firms often fall short is Westwood Independent Financial Planners who the FCA fined £100,000 for mis-selling complex investments in 2013.[15]

Westood should have:

1. Taken reasonable care to ensure recommendations to customers were suitable.
2. Considered what they knew about their customers.
3. Provided information in a clear fair way.

Therefore, to avoid being similarly penalised by the FCA, brokers (and their compliance supervisors) selling LETFs should take steps to ensure that they are fully aware of how to inform their customers properly.

This can be done in a few different ways, including:[16]

1. Complete training in financial compliance themselves.
2. Provide information and training to potential investors.
3. Appoint individuals responsible for Treating Customers Fairly (TCF).
4. Revisit all disclosures.

How could Leo help you do this?

Leo can help you with the above through two of our solutions. The first is our Online Training Solution and the second is our Financial Promotions Solution.

Online Training Solution:

  • 150+ courses to choose from, with those such as Consumer Duty to specifically target the mis-selling risk.
  • Importable and Exportable proof of course completion.
  • Our courses are updated annually or in line with new regulations

Financial Promotions Solution:

  • Structured like a simple questionnaire backed by strong know-how and presented in a pdf report format that is easy to share.
  • The rules of the COBS 4 section of the FCA Handbook are integrated directly into the questionnaire which acts as a checklist and a workflow between marketing sales and compliance.
  • The report is generated in a prose format with any breaches presented in the executive summary and providing time to amend and improve promotions.
  • The reports show evidence of review and compliance and can be shared with relevant executives once done.

These solutions allow you to ensure absolute transparency in the portrayal and public understanding of complex investments such as LETFs and demonstrate an ethical awareness of the dangers mis-selling poses for those buying.

To find out more about how Leo can help you, contact us below

Nous contacter

[1] https://www.ig.com/uk/trading-strategies/leveraged-etfs–what-are-they-and-how-do-they-work–230605
[2] https://www.investopedia.com/terms/l/leveraged-etf.asp
[3] https://www.investopedia.com/terms/l/leveraged-etf.asp
[4] https://www.stockgeist.ai/leveraged-etfs-risks-opportunities/
[5] https://www.ii.co.uk/analysis-commentary/risks-holding-leveraged-etfs-more-one-day-ii513155
[6] https://www.ii.co.uk/analysis-commentary/risks-holding-leveraged-etfs-more-one-day-ii513155
[7] https://www.stockgeist.ai/leveraged-etfs-risks-opportunities/
[8] https://www.investmentweek.co.uk/investment-week/news/2073260/smith-etfs-mis-selling-scanda
[9] See 8
[10] https://neweconomics.org/2012/10/exchange-traded-funds
[11] https://neweconomics.org/2012/10/exchange-traded-funds
[12] https://goodwinbarrett.co.uk/barclays-investment-mis-selling/
[13] https://www.insurancetimes.co.uk/broker-fined-84m-for-mis-selling-accident-insurance-products/1409442.article
[14] https://www.investopedia.com/terms/m/misselling.asp
[15] https://www.fca.org.uk/news/press-releases/tribunal-upholds-fca-fine-firm-misselling-complex-investments
[16] https://www.skillcast.com/blog/avoid-financial-mis-selling
[i] https://www.efmaefm.org/0efmameetings/efma%20annual%20meetings/2012-Barcelona%20old/papers/EFMA2012_0524_fullpaper.pdf

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