The Securities Litigation Expert Blog

Complex Investments Alert: How iShares Made the P/E Ratio Complex

Posted by Jack Duval

May 15, 2014 9:09:00 AM

This blog post continues our expert analysis of complex investments.

One of the most closely watched valuation metrics for equities, equity funds, and indices is the price-to-earnings (“P/E”) ratio.  The higher the price of the investment for a given level of earnings, the higher the P/E ratio, and vice versa.

The P/E ratio gives insight into the price an investor has to pay to buy the earnings of a given investment. It is useful as a metric to make comparisons between different investments and the same investment over time.

iShares Biotechnology ETF (IBB)

However, when investing in the iShares Biotechnology ETF (“IBB”), the reported P/E ratio of 39.62 differs materially compared to the average P/E of its largest holdings.  Amazingly, when calculating the P/E ratio of the IBB, Blackrock does some strange things.  Indeed, the fact sheet states that, “negative earnings are excluded, extraordinary items are excluded, and P/E ratios over 60 are set to 60.”[1]

The table below shows the actual P/E ratios of the top 10 largest holdings in the IBB.

Complexity of iShare ETFs.

 Table 1.  iShares Biotechnology ETF Top 10 Component Analysis[2] 


Thus the actual P/E ratio of the top ten holdings of the IBB is 54.33, not 39.62.  A difference of over 37 percent.  However, the discrepancy is even worse when accounting for all 122 companies in the IBB.  Zerohedge analyzed all 122 IBB component companies and found that 86 of them had negative earnings.[3] They calculated the P/E ratio to be 82.5, or roughly twice the reported P/E ratio.[4]

IBB Price Decline after the Zerohedge Story

As the chart below shows, it appears that investors were unaware of this discrepancy, because after Zerohedge broke the story, the IBB price declined immediately by over one percent.



Hidden Complexity

As we have discussed here, this is another example of how complexity can get baked into an investment in ways that would never occur to an investor (or an advisor) and would be very hard to find in the prospectus.  The P/E ratio is one of the simpler valuation metrics used by financial advisors.  If the IBB has an advertised P/E ratio of 39.62, but its largest constituents have a P/E ratio of 82.5, the investment might behave much differently than expected.


The Accelerant roster of complex investment experts includes:  Steve Pomerantz, Ph.D.Tom Boczar, Esq., CFATom Brakke, CFAGerry Guild, CFA, and John Duval, Sr.

You can find our complete roster of securities experts here.


[1]           iShares Nasdaq Biotechnology ETF; Available at; Accessed May 14, 2014. 

[2]           Source: Google Finance

[3]           Zerohedge; “What Is the PE of the iShares Biotech ETF?  It Depends on Whether You Read the Fine Print”; Available at; Accessed May 15, 2014.

[4]           Id.

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Topics: ETF, Complex Investments, Investment Complexity, Complex Investment Expert, iShares, P/E Ratio

Leveraged and Inverse ETFs: Trojan Horses for Long-Term Investors

Posted by Jack Duval

Aug 28, 2013 2:34:25 AM

Accelerant has a new white paper about leveraged and inverse Exchange Traded Funds ("ETFs"), here.  The paper includes the following:

  • Historical background on ETFs;

  • The introduction of leveraged and inverse ETFs;

  • How leveraged and inverse ETFs have been misused;

  • An explanation of the internal rebalancing mechanism of leveraged and inverse ETFs;

  • A review of prospectus language;

  • A literature review, including popular and financial press, academic, and industry sources;

  • FINRA Suitability Rules;

  • RIA Suitability Regulations, including the fiduciary duty;

  • Supervision and compliance implications for both Broker-Dealers and RIA firms.



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Topics: FINRA, RIA, Leveraged and Inverse, Investment Advisors, litigation, Senior Investors, investments, rebalancing; investments; FINRA, '40 Act; Suitability; Supervision; Compliance, SEC, ETF, Compliance, regulation.

Master Limited Parternship Warning from Morningstar

Posted by Jack Duval

Nov 12, 2012 3:36:40 AM

Morningstar has issued a research note warning investors about the ALPS Alerian MLP ETF (AMLP).  (Morningstar)  The reason?  Hot money is flowing into this ETF because the industry giant, JPMorgan Alerian MLP Index ETN (AMJ), has hit its $5 billion asset limit and stopped creating new units.  This means AMJ is now a closed-end fund and that shares will fluctuate above and below NAV.

Here's what Morningstar has to say about why an ETF structure (as opposed to an ETN structure) is bad for MLPs:

 However, AMLP is not the right vehicle for the majority of investors, and it represents one of the rare cases when buying the ETF structure makes very little sense.

Legally MLPs can make up only 25% of a portfolio registered under the Investment Company Act of 1940. Most mutual funds and ETFs are structured this way. To get around this issue, AMLP is actually structured as a corporation that pays income tax: Before return is passed on to the investor, it must be taxed at the corporate level. Although AMLP's prospectus expense ratio is 0.85%, its gross expense ratio (which accounts for these tax liabilities) is almost 5% as of September. As a result, AMLP has lagged its index significantly. Over the past year AMLP lagged by 10%, and since inception it trailed by a shocking 40%. The upside? When MLPs are down, AMLP declines less because it can reverse some of the deferred tax liabilities it has accrued. For all but the most risk-averse yet desperate-for-yield investors, this downside protection is not enough to make up for the fund's structural issues...

Because of legislation forbidding open-end funds from owning more than 25% of their portfolio in MLPs, AMLP is structured as a C-corporation and pays income tax at the corporate level. Any taxable income from the underlying MLPs is an annual tax liability, and upon the sale of the portfolio's shares they must also pay up at the corporate level. AMLP accounts for these tax liabilities in the NAV, meaning that the total return of the fund can and does trail the index by massive amounts.

Thus the C-Corporation structure eliminates the deferred tax structure inherent in a MLP and pays the taxes along the way.  By Morningstar's calculation, this comes to about 5 percent per year, and causes serious underperformance against the index.


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Topics: Master Limited Partnerships, MLP, AMJ, investments, Master Limited Partnership, Morningstar, natural gas, ETF, ETN, Alerian, AMLP

Complex Products Speech by Finra Chairman and CEO Richard G. Ketchum

Posted by Jack Duval

Oct 1, 2012 4:25:00 AM

This blog post continues our expert analysis of complex investments and their regulation.

Finra Chairman and CEO Richard G. Ketchum delivered some enlightening remarks at the SIFMA Complex Products Forum on September 27, 2012.  (Speech).  The speech is well worth the read.  There are many items of note in Ketchum's remarks.  Some are highlighted below (with useful links at the end):

An attempt at a definition of complex products:

What do we mean by the term "complex product"? Of course, there is no legal definition. I suggest that a basic guide might be the following: A product might be considered complex if the average retail investor probably will not understand how its features will interact under different market conditions, and how that interaction may affect potential risk and return. These types of products merit heightened supervision.

While there are numerous products that fit these criteria, here are a few of my favorite examples:

    • Range accrual notes track multiple assets, such as a stock index and an interest rate. These notes may offer an attractive return if both reference assets behave in a certain way, but may also result in a low or zero yield if those conditions are not met.

    • Products with "worst-of" payoffs are also linked to the performance of multiple reference assets, but in this case theworst-performing asset determines investors' return.

    • Dual-directional notes promise positive returns in both bull and bear markets—subject to strict conditions that can limit an investor's upside while placing principal at risk.

    • Products with reference assets may not be well understood. For example, market volatility products can be misperceived. Instead of tracking actual price fluctuation, these products may invest in volatility index futures that reflect the market's expectation of future volatility.

As one benchmark, if you are embedding imputed derivative exposure, leverage or tracking, an asset class or index with limited liquidity combined with issuer credit exposure, don't think twice—it meets our definition of complex.

How complex products should be supervised:
To be blunt, if you are going to offer these types of products to retail investors, then you must supervise them at every stage. In the words of the great American philosopher, Casey Stengel: "Most ball games are lost, not won." A baseball game is more likely lost through unforced errors, poor judgment and boneheaded play. Often, the team's management will properly be held accountable...

It would be foolish for any firm, including yours, to distribute complex products to retail investors without ensuring that products are vetted, reps are trained and supervised, and risks are disclosed in a way that the average investor can understand. Many complex products are distributed by broker-dealer wholesalers. In reviewing the activities of these wholesalers, FINRA is focusing on their level of understanding of complex products, how they are compensated for promoting them to retail broker-dealers, what they advertise about the products, and how they inform the distributing dealer about the complexities and risks of these products.

Ketchum gives two examples of where there was no reasonable basis suitability determination of different complex products:
In a recent case, a registered rep, Richard Cody, sold asset-backed securities collateralized by installment sales contracts and installment loans for mobile homes, to retail investors with low-to-moderate risk tolerance. The ABS was issued from the eighth of 11 tranches, and thus bore the fourth-highest risk of loss from default of the underlying collateral. For this recommendation, Cody relied on the recommendation of a colleague at his firm. It does not appear that the firm itself vetted the product, and the only documentation that Cody obtained was a printout of basic information from Bloomberg. The investors lost 55 to 66 percent of their investment over 15 months.

In other recent cases, FINRA sanctioned four firms for selling leveraged and inverse ETFs without reasonable supervision and without having a reasonable basis for recommending the securities. We found that the firms had failed to conduct adequate due diligence regarding the risks and features of the ETFs. Reps made unsuitable recommendations to customers with conservative investment objectives or risk profiles. Some of these customers held the securities for months while the markets were volatile. These cases illustrate the harm that can occur if a firm does not properly vet the sale of complex products.

As many of you know, the reasonable basis suitability requirement has been formally incorporated into the new Finra Suitability Rule 2111.

Remarkably, Ketchum discusses a furtherance of the diligence requirement after the complex product is sold:

Assume now that your firm has vetted the structured note, and determined that it may be offered by your financial advisers to the retail market. How will you control distribution to retail customers? Some firms place various limitations on the distribution of a complex product. Distribution might be restricted to certain financial advisers, or might require some form of investor proficiency. Some firms limit the concentration of a customer's liquid net worth in a particular product. Others limit product ownership based on a client's age or investment time horizon. Firms also adopt procedures to ensure that as market conditions change, performance of the product is reviewed. Will your firm have a process to notify the financial advisers when conditions have changed to such a degree that the product presents "tail risks" to your customers?

A fundamental characteristic of many structured products is that it offers upside risk to an asset class that has become the "flavor of the month." It is natural that your customers want to enhance their yield by taking advantage of a hedged investment in an asset that is benefitting from present economic conditions. It is your job to make sure that customers understand the downsides of that investment. It is equally important that you respond quickly if your own firm's analyses of the likely performance of that asset turn out to be too optimistic. No firm's analysis of market movements will be infallible, but it is your responsibility to get your new forecasts quickly to your users and your customers.

In the Cody case, the ABS security was downgraded several times during the year following the recommendations, declining from an A rating to triple-C. Apparently, there was no discussion with the customers concerning the downgrade, nor was any action taken until the market price had dropped from $104 to $41 in 15 months. This case illustrates the problems of selling a complex product without monitoring developments after the sale. In another case, FINRA found that a broker-dealer had sold reverse convertibles to unsophisticated investors, leaving them with highly concentrated positions, in some cases greater than 90 percent.  (Emphasis added.)

Disclosure and risk discussions were also highlighted:
Finally, it is necessary to ensure that customers who purchase the product understand its basic features. Some firms only permit the sale of these products to customers who are qualified to trade options. The sale of complex products through discretionary accounts is a particular issue. As we have repeatedly stated, financial advisers should discuss the basic features of these products with retail customers, and include in the discussion the potential risks of those products under different market scenarios. Other additional steps might be needed to ensure that the recommendation of the structured note is consistent with the investment objectives and risk tolerance of particular customers.  (Emphasis added.)

It is clear from this speech and recent NTMs that there is increased regulatory scrutiny of complex products.  While complex products can certainly be appropriate, broker-dealers face higher compliance, supervisory, and suitability hurdles with them.

Some useful links relating to complex products:

    • Reuters article on Ketchum's speech (Reuters)




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Topics: reasonable basis suitability, Rule 2111, FINRA, Richard G. Ketchum, Reverse Convertible, suitability, supervision, ETF, Complex Investments, Compliance, Complexity

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