Stuart Stothoff Comment On Regulatory Notice 22-08
Stuart Stothoff
N/A
Comments on Regulatory Notice 22-08 I am a self-directed retail user of investing products that is approaching retirement. I do not have a finance background per se, but I have a PhD in engineering with a career revolving around probabilistic risk assessment, and financial concepts translate well. I am not necessarily representative of the “typical” self-directed investor that the regulatory notice is targeting, but I am commenting because any proposed regulations would affect me just as much as any self-directed investor. I have an interest in so-called “complex products” because part of my portfolio uses leveraged and inverse ETFs (geared ETFs or LETFs). As of several years ago, I was an unsophisticated investor just dumping regularly into retirement accounts using index funds. I became interested in LETFs as the prospect of living off my portfolio neared, and became exposed to these products while reading several online forums with other investors that are exploring concepts that use LETFs, options, and futures to obtain leverage. In conjunction with others on these forums, I have heavily researched how these products behave and would have behaved in the past under various economic conditions, including a cross section of various approaches that different investors use. At this point, I am confident that I have a reasonably mature understanding of how such complex products behave, as well as an idea of some of the concepts that retail investors may hold. Contrary to standard disclosures that advertise LETF products as for day trading only, I believe that they can be responsibly held long-term as part of a portfolio when used appropriately. For example, approaches that lever well-diversified low-volatility portfolios using 2x and 3x LETFs are straightforward applications of modern portfolio theory, as long as rebalancing is performed diligently to maintain the risk profile. As an example, a portfolio with 3x S&P 500 balanced with 3x long-term treasuries (e.g., see the thread on the Bogleheads.org forum entitled “HEDGEFUNDIE’s excellent adventure Part II: the next journey”) would have performed very well for the last 40 years. Similar ideas have been popping up in various places. I have been investing using geared LETFs in this way for several years. As a responsible investor, my use of LETFs is intended to augment portfolio performance, while not risking more than I can afford to lose. I do not use options, futures, or cryptocurrency, because LETFs serve my needs and are straightforward to access and use even with relatively small investments. I am not interested in products that are granular (require purchases in large chunks) or illiquid (have stringent restrictions on accessing the investment). I do not consider inverse or leveraged ETFs to be a complex product from the perspective of an investor, even though they may have a sophisticated or complex underlying implementation, because these are strongly analogous to individual stocks, ETFs, and mutual funds. In essence, complexity simply amplifies the risk that the fund may fail to perform, which is a straightforward implication. For the same reasons, I do not consider cryptocurrency to be a complex product per se, even though investors typically do not understand the mathematics of cryptocurrency implementations. I would not be adverse to considering funds that explicitly seek to reproduce the behavior of futures contracts as complex, because futures behavior is likely to deviate from the underlying and the pattern of deviation will change over time. I would consider limited-liquidity funds to be complex, because accessing the fund has highly stylized requirements. I think that the discussion of restrictions on complex products from the industry side is being at least partially conflated with issues of granularity and liquidity. The risk to the investor is much larger for large-granularity and illiquid investments, and a higher level of oversight may be prudent for such investments. From my perspective, investors should be responsible for doing their own due diligence prior to purchasing any investment product to assure that risks associated with the products are in line with their own situation. The due diligence process should include (i) assessment of overall needs and goals, (ii) review of risks and potential rewards of investment products, (iii) matching of investment products to their goals, and (iv) consideration of mitigation strategies to address risks related to undershooting their goals (which may include product underperformance/failure or the opposite, insufficient assumption of risk for the level of investment). When industry provides financial advice about any financial product (“complex” or not), it is serving as part of the due diligence process for the investor. There is a fundamental difference between (i) providing information describing the investment product to a self-directed investor (the investor performs their independent due diligence) and (ii) recommending a financial product (the investor uses industry to provide a due diligence service that the investor is unable or unwilling to fully perform independently). In the first case, industry should bear the responsibility of providing clear, complete, and accurate information, including sufficient information to educate the investor on the risks of the investment product and a range of appropriate contexts in which the product may be suitable or not suitable, and the investor is responsible for evaluating the information for their own particular financial situation. In the second case, industry should bear the responsibility of describing the benefits and risks of the investment product in the specific context of the investor’s particular financial situation, which in turn implies that industry professionals making recommendations should be fully aware of the benefits and risks, with transparent documentation of this awareness. Despite the clear burden for investors to perform due diligence on any financial product, there is no question that a large subset of investors in geared ETFs and complex financial products may not fully understand their investments, the appropriate use of leverage, and potential consequences of their investing strategies. Furthermore, it is in the best interest of both the investor and industry for investors to invest wisely rather than rashly. Nevertheless, it is distressing that industry is contemplating regulating how every investor can access these products based on the lack of due diligence from a subset of potential investors. This is especially distressing for geared ETFs, because they are efficient forms of leverage that even small self-directed retail investors can use effectively. The following addresses the request from comment on complex products for Regulatory Notice 22-08 from the perspective of a self-directed investor. I do not use options and have no basis for specific comments on that portion of the questions. 1. I do not consider inverse or leveraged ETFs to be a complex product from the perspective of an investor, even though the underlying implementation may be sophisticated, because these are strongly analogous to individual stocks, ETFs, and mutual funds. In essence, complexity simply amplifies the risk that the fund may fail to perform, which is a straightforward implication. For the same reasons, I do not consider cryptocurrency to be a complex product per se. I would not be adverse to considering funds that explicitly seek to reproduce the behavior of futures contracts as complex, because the fund behavior may deviate from the underlying. I would consider limited-liquidity funds to be complex, because accessing the fund has highly stylized requirements. 2. It is not clear why “supervising sales and trading of complex products” should be a relevant practice for accounts with self-directed investors. I understand that there are relevant concerns related to liability and protection from loss. a. I am not adverse to additional account approval for products that require periodic actions by the investor or restrict liquidity, but such actions are less important for geared products. b. I think that it is a good idea to provide training for complex products, perhaps even requiring the option of opting out to bypass training, but should not be required. An issue is whether the investor must retrain if switching brokerages, for example. c. I think that it is a good idea to provide educational material on appropriate use of the considered products, including how they are accessed on the investing platform and some examples of appropriate usage. From a practical matter, I strongly suspect that disclosures are largely bypassed by most self-directed investors. d. My impression is that self-directed investors take customer attestations as noise. Maybe this would work as a way to point to educational material? e. Restrictions on access to “complex” products depends on context. I see no benefit to restricting access to geared LETFs, these are liquid and have very small investment granularity. There may be some benefit with respect to products that are illiquid or have large granularity. 3. No opinion 4. No opinion 5. Not relevant to self-directed 6. No opinion 7. I don’t see that classifying whether a product is “complex” is the right metric per se, that’s only a label that potentially covers a wide range of granularity, risk, and liquidity. For example, geared ETFs are arguably the least “complex” and I would argue that little or no additional requirements are needed for such products. Additional requirements may be desirable for large-granularity or illiquid products, though. a. It is only prudent to assess the conditions under which a retail investor would be qualified to transact in any product before it is offered. I have no opinion on how formal such an assessment should be. b. See 7. c. Approval obligations i. Providing educational material to retail investors is an excellent idea over the range of offered products, not just “complex” products. ii. At first blush, it seems like a knowledge check on investors may be reasonable, but I think implementation would be problematic. Is this maintained in a central repository or does it have to be redone individually for every regulated firm? Does it cover all possible complex investments, or are there several checks targeted to different types of investment? Why is there a line drawn between non-complex and complex investments? It may be reasonable to have a threshold on investment size as well (e.g., large investment in large-granularity illiquid investment is checked, small investment in small-granularity liquid investment is not checked). Fair and equitable implementation seems like a hot mess. iii. No opinion d. Continuing obligations i. I don’t see the point in forcing retail customers to perform continuing obligations once the account has been approved. It may be appropriate to ensure review of disclosures for a class of product before the initial transaction in any specific product in the class (e.g., an initial disclosure on geared ETFs suffices). ii. It is prudent to periodically assess whether an investor continues to meet approval thresholds. The investor should be aware that surveillance will occur, however. I have no opinion on whether this business practice should be required. e. It’s not clear what specific obligations are being queried. Above, I indicated opinions on the individual obligations. f. I strongly feel that any investment professional in a position to recommend transactions in any of these products to individual customers should be thoroughly aware of product risks and behaviors, with periodic (annual or biennial) recertification and full documentation. From the investor’s standpoint, it is only necessary to encounter the obligations once (i.e., obligations from intermediaries are superfluous if obligations are otherwise encountered). 8. I don’t think push notifications should be allowed unless the investor opts in after approval for the product. 9. No opinion 10. This question seems redundant to previous questions. I think that industry should treat recommendations with heightened care. I think that industry should provide the capability for education prior to the first investor transaction and require that the investor acknowledges access has been granted to it, but it seems presumptuous to demand proof that the investor has actually digested the education. 11. This is a slippery question, because motivated individuals view required tests on knowledge as noise with no incentive for honesty. I think that it would be a rare individual that is dissuaded from investing in a product because of a failed test, which implies that using testing as a gatekeeper may give the financial industry something to point to that doesn’t actually strengthen protections for the investor. 12. I’m of the opinion that the ultimate responsibility for investing is on the investor and their due diligence. Providing clear plain-language materials that enhance education is a good thing. Discouraging inappropriate investing sounds like a good thing, but finding a suitable methodology is a delicate balance. I am in favor of nudges as a guardrail.
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Stuart Stothoff Comment On Regulatory Notice 22-08
Comments on Regulatory Notice 22-08 I am a self-directed retail user of investing products that is approaching retirement. I do not have a finance background per se, but I have a PhD in engineering with a career revolving around probabilistic risk assessment, and financial concepts translate well. I am not necessarily representative of the “typical” self-directed investor that the regulatory notice is targeting, but I am commenting because any proposed regulations would affect me just as much as any self-directed investor. I have an interest in so-called “complex products” because part of my portfolio uses leveraged and inverse ETFs (geared ETFs or LETFs). As of several years ago, I was an unsophisticated investor just dumping regularly into retirement accounts using index funds. I became interested in LETFs as the prospect of living off my portfolio neared, and became exposed to these products while reading several online forums with other investors that are exploring concepts that use LETFs, options, and futures to obtain leverage. In conjunction with others on these forums, I have heavily researched how these products behave and would have behaved in the past under various economic conditions, including a cross section of various approaches that different investors use. At this point, I am confident that I have a reasonably mature understanding of how such complex products behave, as well as an idea of some of the concepts that retail investors may hold. Contrary to standard disclosures that advertise LETF products as for day trading only, I believe that they can be responsibly held long-term as part of a portfolio when used appropriately. For example, approaches that lever well-diversified low-volatility portfolios using 2x and 3x LETFs are straightforward applications of modern portfolio theory, as long as rebalancing is performed diligently to maintain the risk profile. As an example, a portfolio with 3x S&P 500 balanced with 3x long-term treasuries (e.g., see the thread on the Bogleheads.org forum entitled “HEDGEFUNDIE’s excellent adventure Part II: the next journey”) would have performed very well for the last 40 years. Similar ideas have been popping up in various places. I have been investing using geared LETFs in this way for several years. As a responsible investor, my use of LETFs is intended to augment portfolio performance, while not risking more than I can afford to lose. I do not use options, futures, or cryptocurrency, because LETFs serve my needs and are straightforward to access and use even with relatively small investments. I am not interested in products that are granular (require purchases in large chunks) or illiquid (have stringent restrictions on accessing the investment). I do not consider inverse or leveraged ETFs to be a complex product from the perspective of an investor, even though they may have a sophisticated or complex underlying implementation, because these are strongly analogous to individual stocks, ETFs, and mutual funds. In essence, complexity simply amplifies the risk that the fund may fail to perform, which is a straightforward implication. For the same reasons, I do not consider cryptocurrency to be a complex product per se, even though investors typically do not understand the mathematics of cryptocurrency implementations. I would not be adverse to considering funds that explicitly seek to reproduce the behavior of futures contracts as complex, because futures behavior is likely to deviate from the underlying and the pattern of deviation will change over time. I would consider limited-liquidity funds to be complex, because accessing the fund has highly stylized requirements. I think that the discussion of restrictions on complex products from the industry side is being at least partially conflated with issues of granularity and liquidity. The risk to the investor is much larger for large-granularity and illiquid investments, and a higher level of oversight may be prudent for such investments. From my perspective, investors should be responsible for doing their own due diligence prior to purchasing any investment product to assure that risks associated with the products are in line with their own situation. The due diligence process should include (i) assessment of overall needs and goals, (ii) review of risks and potential rewards of investment products, (iii) matching of investment products to their goals, and (iv) consideration of mitigation strategies to address risks related to undershooting their goals (which may include product underperformance/failure or the opposite, insufficient assumption of risk for the level of investment). When industry provides financial advice about any financial product (“complex” or not), it is serving as part of the due diligence process for the investor. There is a fundamental difference between (i) providing information describing the investment product to a self-directed investor (the investor performs their independent due diligence) and (ii) recommending a financial product (the investor uses industry to provide a due diligence service that the investor is unable or unwilling to fully perform independently). In the first case, industry should bear the responsibility of providing clear, complete, and accurate information, including sufficient information to educate the investor on the risks of the investment product and a range of appropriate contexts in which the product may be suitable or not suitable, and the investor is responsible for evaluating the information for their own particular financial situation. In the second case, industry should bear the responsibility of describing the benefits and risks of the investment product in the specific context of the investor’s particular financial situation, which in turn implies that industry professionals making recommendations should be fully aware of the benefits and risks, with transparent documentation of this awareness. Despite the clear burden for investors to perform due diligence on any financial product, there is no question that a large subset of investors in geared ETFs and complex financial products may not fully understand their investments, the appropriate use of leverage, and potential consequences of their investing strategies. Furthermore, it is in the best interest of both the investor and industry for investors to invest wisely rather than rashly. Nevertheless, it is distressing that industry is contemplating regulating how every investor can access these products based on the lack of due diligence from a subset of potential investors. This is especially distressing for geared ETFs, because they are efficient forms of leverage that even small self-directed retail investors can use effectively. The following addresses the request from comment on complex products for Regulatory Notice 22-08 from the perspective of a self-directed investor. I do not use options and have no basis for specific comments on that portion of the questions. 1. I do not consider inverse or leveraged ETFs to be a complex product from the perspective of an investor, even though the underlying implementation may be sophisticated, because these are strongly analogous to individual stocks, ETFs, and mutual funds. In essence, complexity simply amplifies the risk that the fund may fail to perform, which is a straightforward implication. For the same reasons, I do not consider cryptocurrency to be a complex product per se. I would not be adverse to considering funds that explicitly seek to reproduce the behavior of futures contracts as complex, because the fund behavior may deviate from the underlying. I would consider limited-liquidity funds to be complex, because accessing the fund has highly stylized requirements. 2. It is not clear why “supervising sales and trading of complex products” should be a relevant practice for accounts with self-directed investors. I understand that there are relevant concerns related to liability and protection from loss. a. I am not adverse to additional account approval for products that require periodic actions by the investor or restrict liquidity, but such actions are less important for geared products. b. I think that it is a good idea to provide training for complex products, perhaps even requiring the option of opting out to bypass training, but should not be required. An issue is whether the investor must retrain if switching brokerages, for example. c. I think that it is a good idea to provide educational material on appropriate use of the considered products, including how they are accessed on the investing platform and some examples of appropriate usage. From a practical matter, I strongly suspect that disclosures are largely bypassed by most self-directed investors. d. My impression is that self-directed investors take customer attestations as noise. Maybe this would work as a way to point to educational material? e. Restrictions on access to “complex” products depends on context. I see no benefit to restricting access to geared LETFs, these are liquid and have very small investment granularity. There may be some benefit with respect to products that are illiquid or have large granularity. 3. No opinion 4. No opinion 5. Not relevant to self-directed 6. No opinion 7. I don’t see that classifying whether a product is “complex” is the right metric per se, that’s only a label that potentially covers a wide range of granularity, risk, and liquidity. For example, geared ETFs are arguably the least “complex” and I would argue that little or no additional requirements are needed for such products. Additional requirements may be desirable for large-granularity or illiquid products, though. a. It is only prudent to assess the conditions under which a retail investor would be qualified to transact in any product before it is offered. I have no opinion on how formal such an assessment should be. b. See 7. c. Approval obligations i. Providing educational material to retail investors is an excellent idea over the range of offered products, not just “complex” products. ii. At first blush, it seems like a knowledge check on investors may be reasonable, but I think implementation would be problematic. Is this maintained in a central repository or does it have to be redone individually for every regulated firm? Does it cover all possible complex investments, or are there several checks targeted to different types of investment? Why is there a line drawn between non-complex and complex investments? It may be reasonable to have a threshold on investment size as well (e.g., large investment in large-granularity illiquid investment is checked, small investment in small-granularity liquid investment is not checked). Fair and equitable implementation seems like a hot mess. iii. No opinion d. Continuing obligations i. I don’t see the point in forcing retail customers to perform continuing obligations once the account has been approved. It may be appropriate to ensure review of disclosures for a class of product before the initial transaction in any specific product in the class (e.g., an initial disclosure on geared ETFs suffices). ii. It is prudent to periodically assess whether an investor continues to meet approval thresholds. The investor should be aware that surveillance will occur, however. I have no opinion on whether this business practice should be required. e. It’s not clear what specific obligations are being queried. Above, I indicated opinions on the individual obligations. f. I strongly feel that any investment professional in a position to recommend transactions in any of these products to individual customers should be thoroughly aware of product risks and behaviors, with periodic (annual or biennial) recertification and full documentation. From the investor’s standpoint, it is only necessary to encounter the obligations once (i.e., obligations from intermediaries are superfluous if obligations are otherwise encountered). 8. I don’t think push notifications should be allowed unless the investor opts in after approval for the product. 9. No opinion 10. This question seems redundant to previous questions. I think that industry should treat recommendations with heightened care. I think that industry should provide the capability for education prior to the first investor transaction and require that the investor acknowledges access has been granted to it, but it seems presumptuous to demand proof that the investor has actually digested the education. 11. This is a slippery question, because motivated individuals view required tests on knowledge as noise with no incentive for honesty. I think that it would be a rare individual that is dissuaded from investing in a product because of a failed test, which implies that using testing as a gatekeeper may give the financial industry something to point to that doesn’t actually strengthen protections for the investor. 12. I’m of the opinion that the ultimate responsibility for investing is on the investor and their due diligence. Providing clear plain-language materials that enhance education is a good thing. Discouraging inappropriate investing sounds like a good thing, but finding a suitable methodology is a delicate balance. I am in favor of nudges as a guardrail.