Some fear brouhaha over ETFs could spill over

The Securities and Exchange Commission and the Commodity Futures Trading Commission inserted themselves into the debate surrounding controversial, non-traditional exchange traded funds last week — a debate that could harm the entire ETF sector, according to some industry insiders.

The SEC joined the Financial Industry Regulatory Authority Inc. of New York and Washington on Tuesday in an effort to alert in-vestors about the potential pitfalls of leveraged, inverse and leveraged-inverse ETFs

The two regulators issued an investor alert titled “Leveraged and Inverse ETFs: Specialized Products with Extra Risks for Buy-and-Hold Investors.”

“Not all ETFs are created equal,” John Gannon, senior vice president for investor education at Finra, said in a statement.

“Over time, leveraged and in-verse ETFs can deviate substantially from the performance of the underlying benchmark, particularly in volatile periods. They are highly complex financial instruments that can turn into a minefield for buy-and-hold invest-ors,” Mr. Gannon said.

Meanwhile, the CFTC of Washington last Wednesday revoked re-lief it granted DB Commodity Services LLC, a New York unit of Frankfurt, Germany-based Deutsche Bank AG, permitting its exchange traded commodities funds — which are so similar to ETFs that they are often referred to as such — to exceed federal speculative position limits in corn, soybeans and wheat futures.

The CFTC has been investigating concerns over excessive speculation in futures markets epitomized by the run-up in oil prices last year and in 2007 — speculation that it thinks exchange traded products may have helped facilitate.

The first-of-its-kind ruling affects the PowerShares DB Commodity Index Tracking Fund (DBC) and PowerShares DB Agriculture Funds (DBA), which likely will have to sell parts of their agricultural positions.

The funds are managed by DB Commodity Services and marketed by Invesco PowerShares Capital Management LLC of Wheaton, Ill.

Investors have noticed the debate concerning non-traditional ETFs, which, unlike traditional ETFs, don’t simply follow an index of underlying stocks.

The problem is that clients don’t always differentiate between non-traditional and traditional ETFs, said Herb Morgan, chief executive of Efficient Market Advisors LLC, a Del Mar, Calif.-based financial advisory firm with $900 million under management.

He said he has received “one or two” questions from clients concerned about investing in ETFs, because some brokers have re-stricted or banned the sale of leveraged and inverse ETFs.

Finra warned brokers in June that inverse and leveraged ETFs “typically are unsuitable for retail investors” who hold them longer than a day.

The regulator clarified its position on such ETFs in a podcast July 13 in which it said that member firms could recommend that a retail investor hold them for longer than one day, provided a suitability assessment is conducted with respect to such an investor and the ETF.

But the clarification has done little to prevent some brokers from restricting, or in some cases banning, the sale of leveraged and inverse ETFs.

The brokerage firms include Ameriprise Financial Inc., Edward D. Jones & Co. LP, LPL Investment Holdings Inc., Morgan Stanley Smith Barney and UBS Financial Services Inc.

“If people don’t do enough research to know the difference [between traditional and non-traditional ETFs], I think it could give some people the wrong impression,” Mr. Morgan said.

‘NOT CREATED EQUAL’

There is no doubt that problems facing non-traditional ETFs are causing investor confusion, said Jim Ross, senior managing director at State Street Global Advisors of Boston.

“I have been spending a lot of time recently trying to get this point across — that not all ETFs are created equal,” he said.

Others share his frustration level.

“We’re concerned,” said Mike Latham, co-head of the iShares ETF business, a unit of Barclays Global Investors of San Francisco.

But that concern is tempered by the belief that the industry is doing a good job at educating investors, he said.

There may be some confusion about non-traditional and traditional ETFs, but most investors understand the differences, Mr. Latham said.

The most recent data indicate that he may be right.

Assets in all ETFs rose 8% to $643.4 billion at the end of last month, from $597.5 billion at the end of June, according to the National Stock Exchange Inc. of Jersey City, N.J.

But assets in ETFs offered by ProShare Advisors LLC of Bethesda, Md., and Direxion Funds of Newton, Mass. — the two largest providers of leveraged and inverse ETFs — fell 7% to $30.32 billion at the end of last month, from $32.67 billion at the end of June.

DROP IN ASSETS

The drop in assets experienced by leveraged- and inverse-ETF providers could be the result of many things, but industry experts said it is telling that it occurred during a month when such ETFs were under fire.

Assets in exchange traded products specializing in commodities dropped by a similar percentage.

They were $54.54 billion at the end of last month, a decrease of almost 9% from $59.9 billion at the end of June, according to the National Stock Exchange.

The numbers seem to be an early indication that while the fracas over leveraged and inverse ETFs and exchange traded commodities funds may have an impact on those products, it is unlikely to have wider implications for the industry, said Gary Gastineau, principal of ETF Consultants LLC of Summit, N.J. He is one of the pioneers who first brought ETFs to market in 1993.

“It seems to me, each product will be evaluated on its own,” Mr. Gastineau said. “If there is a problem it’s going to rebound on a particular fund, not on the entire industry.”

That may be true, but it does seem as if the industry is playing with fire — particularly with regard to leveraged and inverse ETFs, some observers said.

“The products do serve a useful purpose,” said Herb Blank, senior vice president of Rapid Ratings International Inc. of New York and an ETF industry consultant. “I just wish it were possible to put a surgeon general warning on them.”

E-mail David Hoffman at [email protected].

Related Topics: E*Trade Financial Corp., ETF Insights