As exchange-traded funds continue to grow in scope and popularity, investment experts warn that some products, such as leveraged and inverse ETFs, may be too dangerous for all but the most experienced investors.
"People get lazy, and they think an ETF is an ETF," said Paul Schatz, the president and CEO of Heritage Capital LLC, a Woodbridge, Conn., registered investment advisory firm. "There are inherent problems with every product, and some products have way too much firepower for the average person to use."
Exchange-traded funds operate in a regulatory gray zone. Though the Securities and Exchange Commission considers that equity ETFs fall under the Investment Company Act of 1940, there is no explicit provision for them, and the SEC must issue an exemptive order for each ETF proposal. Commodity-based ETFs are regulated by the Commodity Futures Trading Commission, but the SEC also oversees them and still must issue a "no-action" letter for each one.
The SEC is considering a proposal that would let ETFs begin trading without having to wait for SEC approval, said Cary Stier, managing partner of U.S. asset management services at Deloitte & Touche. He said the proposal would eliminate unnecessary regulatory burdens and facilitate ETF competition and innovation.
Though it often takes more time to get approval, ETFs can already do things that most mutual funds cannot, such as trading throughout the day on an exchange instead of at the day's closing price and using leveraged and inverse trading techniques in creative ways.
Officials at the Financial Industry Regulatory Authority and SEC are examining ways to better monitor ETFs. In August, the two agencies put out a joint release alerting investors to the dangers of leveraged ETFs, which seek to deliver multiples of daily performance against their index or benchmark; inverse ETFs, which let investors hedge downward-moving markets, and leveraged inverse ETFs, which seek a return that is a multiple of the inverse performance of the underlying index.
"The best form of investor protection is to clearly understand leveraged or inverse ETFs before investing in them," according to the alert. "No matter how you initially hear about them, it's important to read the prospectus, which provides detailed information related to the ETFs' investment objectives, principal investment strategies, risks and costs."
These products have warning labels, but they still attract inexperienced investors. "If you look at the prospectus, it says these are supposed to reflect 'daily' performance," said Kathleen Moriarty, a partner at the Katten Muchin & Rosenman law firm. "Some people don't understand that these investments are changing every day" and should not be held onto.
Leveraged and inverse ETFs use several investment strategies to accomplish their objectives, including swaps, futures contracts and other derivative instruments. They are meant to perform for a specific period, such as a day, and their mathematics do not support a buy-and-hold strategy, she said.
"I often feel like I'm talking to a blank wall" when explaining compounding to clients, Moriarty said. "Advisers should encourage potential investors to at least read the summary prospectus on these products so they understand exactly what they're investing in."
Some advisers say they hate leveraged ETFs and refuse to use them because of the confusing way they use compounding. Leveraged and inverse ETFs are designed to be traded daily, not held for several days or longer. When held for several days, weeks or months, double and triple inverse or leveraged ETFs can plummet into a vortex of losses that bears no resemblance to the underlying index.
Though they may be complicated, leveraged and inverse ETFs are not necessarily bad; they just need to be used carefully by experienced investors. "I don't think any investor who is working with an adviser sits down and reads prospectuses," said Heritage Capital's Schatz. "That's why they hire us."
"Investors rely on us as advisers to read through these and make sure they're suitable," added Paul Simon, the chief investment officer at Tactical Allocation Group in Birmingham, Mich. "Even prescription drugs can be bad for you when they're misused."
Simon said that leveraged and inverse ETFs have a limited, specialized use as a means for investors to hedge risk.
"Leveraged ETFs are inherently going to be more volatile," he said. "Last year's market was like throwing gas on a fire. These are really trading vehicles and are not meant to be bought and held. There's a big difference between speculating and investing."
Schatz said that he was initially concerned about the liquidity of leveraged ETFs but realized that they are as liquid as their underlying index and that most ETFs are immensely liquid. Though he said he does not personally use them, these products are successfully used by brokers at wirehouses, independent financial advisers, hedge funds and individuals who day-trade.
"They are fine so long as you recognize the shortfalls of the vehicle you're using," he said. "You can trade with a 3x [triple leveraged] financial-sector ETF, but financials are already volatile with just 1x. That's an awful lot of gunpowder to play with."
While there were 785 U.S.-domiciled ETFs as of the end of September, three providers — Barclays Global Investors, State Street Global Advisors and Vanguard Group — account for 82% of the nearly $700 billion in total ETF assets, according to the National Stock Exchange.
Investors are drawn to the products for their flexibility, diversification and lower fees than mutual funds, said Cary Stier, managing partner of U.S. asset management services at Deloitte & Touche.
Generally, ETFs are more tax efficient than open-ended mutual funds due to the way thatthey redeem investors in-kind, instead of selling portfolio securities to fund shareholder redemptions, accordin to Stier.