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BlackRock CEO Fink's comments on exotic funds divide ETF community

May 29, 2014 @ 1:20 pm

By Trevor Hunnicutt

blackrock, laurence fink, leveraged etfs
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BlackRock CEO Larry Fink (Bloomberg News)

“And … trade,” says a bespectacled, khaki-wearing man, pressing a button on his smartphone.

“You, sir, are the sultan of swagger,” a deep, disembodied voice intones. “This is the Fellowship of the Bold, and you are the Grand Poobah, because you know how it feels to make a Direxion Shares 3X Leveraged ETF trade.”

The monologue is interrupted by a phone ringing. The trader picks up: “Hey honey. Milk? Bread? You got it.”

Leveraged exchange-traded products — and their cousin, the inverse ETP — have been challenged for years by shareholder lawyers and regulators. Yet the products have managed to not only survive but become a favored tool for some investors.

They've also become an important part of the growth strategy of firms like the one responsible for this television spot, “Fellowship of the Bold,” which embraces the family-man ordinariness of their customers, while at the same time acknowledging — at the end of the commercial — the very extraordinary power, and risk, their exotic funds could pose to unsophisticated investors.

Earlier this week, one of the dominant forces in the $2.49 trillion ETF universe added his voice to the debate when Laurence D. Fink, chief executive officer of the world's largest ETF business, unexpectedly slammed the leveraged products.

The BlackRock chief executive said the funds contain a structural problem with the potential to “blow up” the industry.

“BlackRock would never do a leveraged ETF,” the BlackRock chief told Deutsche Bank AG co-chairman Anshu Jain at an event Wednesday in New York, according to Bloomberg News. Mr. Fink said he doesn't even understand why the Securities and Exchange Commission allows them to operate.

The remarks drew sharply polarized reaction in among some fans of the exotic products, many who said the comments smacked of odd jealousy as the vast and successful firm lacks its own lineup.

“He doesn't have any … so he may as well bitch about them because he sees money flow going in that direction,” said ETF Digest's Dave Fry of Mr. Fink. “Traders love using them. I use them, but I use them tactically and over short periods — that's what they're for.”

(Also: Read S&P Capital IQ's Todd Rosenbluth's take on leveraged ETFs)

BlackRock spokeswoman Melissa Garville declined to comment.

Direxion is just one of the host of firms looking to gain traction with offbeat products in an ETF market dominated by three firms, where launching more basic investment strategies — me-too products — is often seen as a fruitless endeavor by all but the largest companies.

“ETFs for large common asset classes have become commoditized,” wrote Adam Nash recently. Mr. Nash is CEO of Wealthfront Inc., an online advisory firm that manages more than $800 million in portfolios built in large part with ETFs.

There are 187 leveraged or inverse exchange-traded funds and notes representing about 2% of the nearly $1.8 trillion in U.S. exchange-traded products, according to research firm XTF Inc.

(See ETF Database's list of leveraged ETFs)

The major providers in the space also include ProShares and VelocityShares. Executives at those firms were not immediately available or declined to comment.

But Brian Jacobs, Direxion's president, said Mr. Fink's criticisms caused him to scratch his head. He said the products are well regulated and transparent. His firm took in $1.8 billion in flows in the last year, research firm Morningstar Inc. estimates. They have $7 billion in ETFs overall.

“If there's concern about embedded leverage in financial products, you could clearly find many other products with a lot more leverage than these,” he said, bringing up home mortgages as an example. “This is the one area that BlackRock does not participate in … You do wonder why he would make such a provocative statement when the facts don't bear it out.”

The statement unearthed a touchy subject for the brokerage community.

In 2009, regulators warned the funds were complex and risky. In the years since, major firms have been haunted by fines for selling the products.

Broker-dealers including Morgan Stanley Wealth Management, Wells Fargo & Co. and UBS AG have been fined in connection with selling the exotic securities to mom-and-pop investors.

Just this year, the Financial Industry Regulatory Authority Inc. fined Berthel Fisher & Co. Financial Services Inc. and Stifel, Nicolaus & Company Inc. after the companies sold the funds.

Many brokerages now reportedly place strict limits on sales of the products.

Unlike most ETF funds, which are designed to hug indexes, leveraged and inverse fund returns can dramatically vary from benchmarks over a long period of time. For that reason they're generally considered unsuitable for buy-and-hold investors.

Brad Stratton, an adviser at CONCERT Wealth Management Inc., said the funds can be used to provide useful short-term exposures. Beyond single-day exposures, there are clear risks, he said.

“It's like sitting at the casino table too long — the odds are set against you,” Mr. Stratton said. “It all comes down to full disclosure, if the documents that are presented and the products and marketing material disclose how these vehicles work.”

BlackRock, which backs the popular iShares ETF lineup, has been the target of regulatory scrutiny itself. The firm, and some of its competitors, are fiercely battling being labeled a systemically important financial institution by regulators.

The SEC declined to comment. Spokeswoman Judith Burns, however, pointed to a 2012 speech by Norm Champ in which the director of the commission's division of investment management said, “because of concerns regarding leveraged ETFs ... we continue not to support new exemptive relief for such ETFs.”

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