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Some of the world’s largest asset managers are proposing an overhaul in the way leveraged exchange traded funds are sold to retail clients, as advocates in Canada call for more investor protection at discount brokerages that sell these high-risk funds.

After a month of shocking losses in a number of high-profile leveraged oil ETFs, six asset managers – including investment behemoths BlackRock Inc., Vanguard Group Inc. and Charles Schwab Investment Management Inc. – published a joint letter this week recommending stock exchanges and regulators narrow the definition of what can be called an exchange traded fund, or ETF.

Leveraged ETFs, which use complex derivative contracts to magnify returns, are far riskier than traditional ETFs, which typically own a basket of securities and passively follow indexes. Derivative-based funds can act in unexpected ways in moments of market stress, and the use of leverage can compound losses rapidly.

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The concern is that unsophisticated retail investors are buying products they don’t understand and that are really designed for speculative day trading.

“Regulators need to take another look at these exotic products, which do not perform the way most retail investors would expect ETFs to perform,” said Ermanno Pascutto, executive director of the Canadian Foundation for Advancement of Investor Rights (FAIR), an investor advocacy group.

In Canada, the BetaPro Crude Oil 2x Daily Bull fund (HOU), run by Horizons ETFs Management (Canada) Inc., saw the value of its assets drop 87 per cent in a single day in April, as the price of oil futures contracts collapsed. Investors had piled into the fund in record numbers in April, and HOU was the most traded security on the Toronto Stock Exchange for the entire third week of that month. Those who tried a buy-and-hold strategy for the fund, which is designed explicitly for day trading, were almost entirely wiped out.

Investors suffered similar losses in 2018 using leveraged products tied to the VIX, an index that tracks market volatility.

Canadian investor advocates have renewed their focus on leveraged funds in recent weeks, after the oil fund debacle. FAIR Canada first raised concerns about leveraged funds with regulators in 2009.

“Our position is still the same as it was back then in that these products should not be called ETFs. They are not regular stock products – they are future contracts," Mr. Pascutto said.

FAIR is also suggesting that online discount brokerages implement stricter investor protection measures, such as having investors sign risk disclosure and acknowledgement forms.

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The use of discount online brokerages – which are particularly popular among younger investors – has grown exponentially. About 30.5 million trades were executed through Canada’s online brokerages in the first quarter of 2020, an increase of 91 per cent from the prior quarter, according to the Retail Brokerage and Distribution Report by Investor Economics.

The challenge is that the Canadian investor protection rules cater far more to investors who use financial advisers. As Steve Hawkins, chief executive of Horizons, explained: “If an investment adviser wants to trade a leveraged or inverse leveraged product for the client, then they would have to get the client to sign a piece of paper acknowledging the risks."

There is nothing comparable for investors who trade on their own with discount brokerage accounts.

IIROC’s regulatory guidance prohibits all online trading platforms in Canada from offering any type of advice. Therefore, retail clients must make their own investment decisions without receiving any recommendations or suitability assessments from online brokerages.

“A challenge in this industry is that discount brokerages are divorced from advice because of how they’re regulated,” a spokesperson for Wealth Simple, which runs a discount brokerage, Wealthsimple Trade, said in an e-mailed statement.

Canadian Securities Administrators spokesperson Ilana Keleman said the discount channel is designed for self-directed investors who can develop their own investment plan, identify and manage risks on their own and make their own trades.

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“Many retail investors do not fit this description, and are better suited to the advice channel, where they will get help assessing products and risk,” Ms. Keleman said in an e-mail.

This isn’t the first time investor advocates and asset managers have asked for industry-wide change. After the 2018 sharp volatility spikes in the U.S. equity market, Blackrock Asset Management Canada petitioned for leveraged products to not share the same label as more plain vanilla funds. Yet, despite international meetings in 2018, initiatives never took off in Canada, Mr. Pascutto says.

The U.S. asset management giants, who sent the letter to regulators this week, are now asking for all exchange traded products to be broken down into four categories with different names: exchange-traded notes, exchange-traded commodities or exchange-traded instruments (ETIs) as well as regular ETFs. (Leverage funds would fall into the ETI category.)

In Canada, Horizons ETFs is the only company that sells leveraged funds, offering 25 different products. Mr. Hawkins says the company goes “above and beyond” regulatory requirements by providing clearly marked enhanced disclosure documents and posting online investor education to their website.

Horizons has also worked with some discount brokerages, such as TD Direct Investing, to offer educational sessions for investors about how to correctly use its risky products, Mr. Hawkins said. But not all brokerages are willing to give ETF companies like Horizons access to their user base.

“If they don’t want us talking to their end client, and they don’t want to help us educate their end investors that are using their account, we have no control over that,” Mr. Hawkins said.

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There have been discussions with Canadian regulators in the past about providing risk-disclosure warnings that would pop-up when people log into direct investing accounts, similar to explainers that appear when there’s a stock split or consolidation, Mr. Hawkins said. He would not go into details about the discussions, but said he thought idea would be difficult to implement.

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