Feds Scrutinizing Derivatives in ETFs

By: Ron_Rowland

Last week I told you about political risk in exchange traded funds (ETFs). Almost as if on cue, later that very day, the Securities & Exchange Commission (SEC) announced it is conducting a “review” of ETFs that use derivatives.

What? Derivatives in ETFs? Yes, and it’s nothing new. In fact, the SEC made clear it is also looking into mutual funds for the same thing!

To understand what is happening here, we need to look under the hood of the fund engine for a minute …

“Derivative” Is Not a Dirty Word

Some investors freak out when they hear the D-word. Yet derivatives are just a tool. Like all tools, they can be very useful if they’re handled properly. If not, they can do a lot of damage.

Tools are extremely useful when used properly.

“Derivatives” is a broad category, covering futures, options, swaps, and other assorted instruments. Mutual funds have been using stock index futures to quickly adjust their market exposure for decades. So this kind of activity is fairly routine. And when done right, it’s no riskier than buying and selling the actual stocks that make up an index.

What wasn’t routine, until fairly recently, was the practice of building a mutual fund or an ETF entirely from derivatives instead of stocks and bonds. Again, this isn’t necessarily a bad thing and can actually bring some advantages.

You see, ETF providers are always looking for ways to make their products more attractive. Derivatives allow them to add features like leverage and commodity index tracking. These features also create new and different kinds of risk.

Risk, like energy, can neither be created nor destroyed. It can only be moved around. The real question is who takes the risk — and whether they know they’re taking it.

That could explain why the …

SEC Is Taking a Closer Look

On March 25, SEC chairperson Mary Schapiro said,

“We want to be sure our regulatory protections keep up with the increasing complexity of these instruments and how they are used by fund managers.”

The agency has therefore announced a temporary halt to the registration of new ETFs and mutual funds that rely on derivatives to achieve their goals.

The SEC has placed a temporary halt to new ETFs using derivatives.

Existing funds are not affected by this action — yet. There is no doubt, though, that many investors don’t understand what they are getting into when they buy derivative-based ETFs. (See my Money and Markets columns on Inverse ETFs and Leveraged ETFs if you want to educate yourself.)

I don’t believe the funds are at fault here. The firms that specialize in this niche — mainly Direxion, ProShares, and Rydex — all provide plenty of disclosure and educational materials. It’s all there in the fine print. I really don’t know what else they can do.

My guess is that what we’re seeing is a skirmish in a bureaucratic turf war …

Last year the Commodity Futures Trading Commission (CFTC) decided to enforce “position limits” on certain futures contracts used by resource-linked ETFs. The impact was immediate. I wrote about it at the time and the problem is still not resolved.

Of course, it may be that the SEC and CFTC are actually trying to put their heads together and figure out what is best for investors. I hope so. It would be a shame if they prevent people from buying products they clearly want and that the industry obviously wants to supply.

On the other hand, if derivative-based ETFs have some kind of fatal flaw that keeps them from working right in the long run, then the SEC has the power to stop them. What they can’t stop is innovation. Which brings us to my final point …

A Curious Omission: ETNs

The SEC review appears to leave out exchange-traded notes — a type of investment that looks a lot like an ETF but is actually a bond tied to an index.

Because they are not technically “investment companies,” ETNs fall under a different set of regulations. And the rules under which the SEC has stopped the registration of new, derivate-based ETFs do not appear to apply to ETNs.

The SEC has new derivative-based ETFs in its crosshairs but not ETNs.

Rules can be changed, of course. But as it stands right now, we’re seeing a situation where fund sponsors are being pushed toward offering new products in ETN format rather than as ETFs.

This is a problem because ETNs carry an additional risk, which I wrote about last year. They can be useful sometimes. But, other things being equal, I prefer ETFs …  especially after seeing the failure of supposedly rock-solid firms like Bear Stearns and Lehman Brothers.

So what does it all mean for you? Right now, not much. If you use commodity, leveraged or inverse ETFs, you can keep on doing it. Just be aware that your favorite funds may be in the regulatory crosshairs.

Best wishes,

Ron

P.S. Are you following me on Twitter? Check out http://www.twitter.com/ron_rowland for frequent updates, personal insights and observations about the world of ETFs.

Weiss and Weiss Research analysts offering the latest investing news and financial insights for the stock market, including tips and advice on investing in gold, energy and oil. Dr. Weiss is a leader in the fields of investing, interest rates, financial safety and economic forecasting. To view archives or subscribe, visit http://www.moneyandmarkets.com.

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