SEC uses single-inverse ETFs as vehicle to teach Wells Fargo same old lesson.

Do you know what a single-inverse ETF is? We’re going to be honest and tell you it wasn’t on the tip of our tongues.

Single-inverse ETFs

But the SEC will tell you that:

Single-inverse ETFs are complex financial instruments that seek investment results that are the opposite of the performance of an index for a stated trading period, typically a single day. When held longer than a day, particularly in volatile markets, investors may experience large and unexpected losses. . . [and] will lose money when the level of the index is flat. [That is], even if the index performance is zero percent, the single-inverse ETF based on that index will lose money. . . . [P]rospectuses also state that investments in single-inverse ETFs should be actively monitored as frequently as daily.

And so it was that the SEC began its recitation of the allegations against Wells Fargo Advisors Financial Network and Wells Fargo Clearing services in an administrative order on February 27th.

What Wells Fargo Knew about Them

It turns out that Wells Fargo knew all about these ETFs, or at least knew about “non-traditional” ETFs. FINRA issued guidance on them 11 years ago in the form of Regulatory Notice 09-31. FINRA warned there that “inverse and leveraged ETFs that are reset daily typically are unsuitable for retail investors who plan to hold them for longer than one trading session, particularly in volatile markets.” The SEC and FINRA staffs followed up with a joint investor alert in August 2009 that said, among other things, “Investors should be aware that performance of these ETFs over a period longer than one day can differ significantly from their stated daily performance objectives.”

In May 2012, a number of Wells Fargo entities were actually sanctioned by FINRA and paid over $2.7 million for (1) failing to establish a reasonable supervisory system and written procedures to monitor the sale of non-traditional ETFs; (2) failing to provide adequate formal training and guidance to registered representatives and supervisors regarding non-traditional ETFs; and (3) certain Wells Fargo registered representatives making unsuitable recommendations of non-traditional ETFs to certain customers with conservative risk tolerances.

So yes, Wells Fargo knew about non-traditional ETFs and had even been through the regulator ringer over them before. And yet . . .

What Happened Here

The SEC’s February 27 order found that from April 2012 through September 2019: 

• Wells Fargo’s policies and procedures were not reasonably designed to prevent and detect unsuitable recommendations of single-inverse ETFs. 

• Wells Fargo failed adequately to supervise its employees’ recommendations regarding single-inverse ETFs, and did not adequately train them concerning those products. 

• Some Wells Fargo brokers and advisers did not fully understand the risk of losses these complex products posed when held long term. As a result, some Wells Fargo investment advisers and registered representatives made unsuitable recommendations to certain clients to buy and hold single-inverse ETFs for months or years. (We’ll discuss those italics below.)

According to the order, a number of these clients were senior citizens and retirees who had limited incomes and net worth. The SEC says that all of this amounted to violations of Section 206(4) of the Advisers Act and Rule 206(4)-7, as well as the supervisory provisions of Advisers Act Section 203(e)(6) and Exchange Act Section 15(b)(4)(E).

Wells Fargo is paying a $35 million penalty that will be distributed to clients who were recommended to buy single-inverse ETFs and suffered losses after holding the positions for longer periods. Interestingly, Wells Fargo itself is being compelled to undertake responsibility for making those distributions.

What We Think

Look, you might not understand what every investment product under the sun is, and you don’t have to. But if you’re an investment adviser, you do have to understand the products your clients are invested in. If you’re a registered rep, your customers’ products have to be suitable or them. Even if single-inverse ETFs are exotic, these principles are not. We italicized the language above just to point out those simple concepts. Educate your people, stay up to date on where your clients are invested, and don’t let them languish in investments that don’t make any sense for them.