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Understanding FINRA Suitability Rule 2111 - Leveraged and Inverse ETF Suitability

Posted by Jack Duval

Dec 17, 2013 6:56:00 AM

This blog post continues our expert series addressing FINRA Suitability Rule 2111.  Our suitability experts will examine the genealogy of the rule and how it has evolved over the years through Notices to Members, Regulatory Notices, and changes to the rule itself.  In particular, customer-specific and reasonable-basis suitability will be examined.

ETF Specific Suitability

Leveraged and inverse ETFs are not suitable for most investors because they are (respectively) speculative and aggressive investments.  In order to understand why these investments are speculative and aggressive it is helpful to define those terms.


Speculation is a term of art within the investment world and it has a very specific meaning, in particular, it indicates the high probability of the complete, or near complete, loss of the entire investment.  A classic example of a speculative investment is purchasing an out-of-the-money (“OTM”) call option on a stock.

When you purchase an OTM call option, it has a fixed amount of time before it expires worthless.  If the underlying stock does not rise above the strike price before the expiration date, the call option will become worthless and the investor will have lost the entire premium she paid for it.


Aggressive investments are also a term of art within the investment world.  An aggressive investment is one in which there can be expected large and violent price movements, but which do not have a high likelihood of a total loss. A good example of an aggressive investment is an investment in a stock market index such as the S&P 500 or the NASDAQ index.

As recent investors in the above indicies can attest, both have experienced extreme volatility over the past 14 years. Indeed, the S&P 500 declined approximately 45 percent twice and the NASDAQ declined approximately 70 percent and 50 percent over the same time period.  While these investments are extremely volatile, they carry a much smaller risk of complete loss than a stock option, and thus are in a different category.

Investment Math

Additionally, the more speculative or aggressive an investment is, the more closely it must be watched and the more active management it requires.  This is due to what is commonly referred to as “investment math”. If an investor holds an investment that declines by 50 percent and then rises by 50 percent, they are still down 25 percent on a dollar basis.  The reason for this is that the positive 50 percent return came after the investment had already declined by 50 percent, so it was a 50 percent return on a “50 percent investment”.  Thus that return was only 25 percent of the original investment.

A simple example is instructive. If an investor invests $100,000 and it declines to $50,000, a 50 percent return on the $50,000 only gets her back to $75,000.  She is still down $25,000 on her original investment.  What is needed is a 100 percent return after the original decline (because a 100 percent return on $50,000 is $50,000 and this would get her back to her original investment value).

This investment math is why investors who have been invested in the broad stock market since 2000 have the same portfolio value 13 years later.  They suffered through two declines of around 50 percent and subsequent recoveries of around 100 percent but their portfolios are at the same approximate value as when they started.

Using broad asset allocation rebalancing on a quarterly or annual basis is a way to more actively manage aggressive positions. However, more frequent management may be warranted given an investment’s specific traits. In particular, leveraged and inverse ETFs require constant vigilance and frequent (even daily) rebalancing by the advisor if they are held longer than one day.

As discussed in other posts, leveraged ETFs are speculative because the use of leverage magnifies the deleterious effects of internal rebalancing to maintain constant leverage. Simply put, the more leverage used, the faster the ETF declines towards zero.


Portions of this blog originally appeared in the Accelerant white paper Leveraged and Inverse ETFs:  Trojan Horses for Long-Term Investors, by Jack Duval.  

The Accelerant Securities Practice Group has many experts on FINRA Suitability Rule 2111, including: Gerry Guild, John Duval, Sr., Tom Brakke, and Jack Duval.


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Topics: Investment Suitability, FINRA Suitability Rule 2111, Suitability Expert, Leveraged and Inverse ETF, Speculative and Aggressive Investments

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