State regulators aren’t nuts about souped-up ETFs

State securities regulators are advising retail investors to understand the risks, costs and tax consequences of exchange-traded funds before they buy the increasingly popular products.
The North American Securities Administrators Association said traditional ETFs — which are baskets of stocks, bonds, commodities, currencies and derivative instruments created to copy the performance of an underlying sector or index, may be suited long-term investors.
But leveraged and inverse ETFs may be too complex for the average investor to understand and require daily monitoring, the association said in its investor alert today. The state regulators said two years ago that unsuitable ETF sales were a threat to retail investors.
Leveraged funds use debt and derivatives to hike returns. Inverse ETFs, which employ options strategies, allow investors to short an index.
“We continue to actively scrutinize a variety of issues related to ETF sales practices, such as point of sale disclosures, and the suitability of these products, particularly inverse and leveraged ETFs for long-term investors,” said NASAA president David Massey, who also is North Carolina’s deputy securities administrator.
ETFs have become enormously popular. More than 1,000 of the funds exist, with a total worth topping $1.1 trillion, according to the Investment Company Institute, which represents the companies that sell ETFs and mutual funds.
The trade group did not have an immediate comment about the regulator’s warning
NASAA said leveraged funds and inverse ETFs can incur substantial brokerage fees and commissions because they must be traded all the time. Additionally, these types of complex ETFs may be less tax efficient because daily resets within the funds can result in short-term capital gains that may not be offset by a loss, the association said.
Morningstar ETF research analyst Patricia Oey said about 3% of ETF assets are in leveraged and inverse funds and the bulk of investors in these products are not retail investors. She also agreed that they are probably not suitable for retail investors.
Capital gains were paid out to only about 5% of the assets that were investing in leveraged and inverse ETFs, according to Ms. Oey.
“There’s nothing wrong with ETF investing,” Mr. Massey said. But regulators worry someone will buy the products, such as online, “without understanding what they are getting into.”
Investors who seek help from an investment adviser or even a broker may incur a higher cost, “but it has advantages to it in the inquiry that is made about the financial situation of the investor” and the suitability of such an investment, Mr. Massey said.