Hedge Fund ETF weapons turn dangerous for smaller investors

If you are convinced, really convinced, the price of crude oil will rise today and U.S. stocks will fall, Factor Advisors LLC has an exchange-traded fund for you.

The FactorShares 2X: Oil Bull/S&P500 Bear offered by the New York-based firm makes a two-times long wager on crude oil futures and a short bet on Standard & Poor’s 500 Index futures, in effect delivering twice the daily change in the spread between the two positions. The product’s birth followed “a lot of feedback” from institutional investors, including hedge funds, Stuart Rosenthal, chief executive officer of Factor Advisors, said in a telephone interview.

As the biggest ETF managers capture assets from traditional mutual funds with benchmark-tracking offerings, smaller competitors are catering to sophisticated investors with an increasingly complex arsenal of products. Often based on derivatives, these can be weapons for savvy investors to amplify wagers on rising or falling prices of everything from stocks and bonds to currencies and commodities. The same tools, readily available through conventional and online brokers, have proven hazardous for individual investors who sometimes misunderstand and misuse them with costly consequences.

“If you make it available to the masses, watch out, because the masses might buy them,” Paul Justice, an analyst with Chicago-based fund researcher Morningstar Inc., said in a telephone interview.

Price Gyrations

Earlier this year, notes issued by Credit Suisse AG lost half their value in two days as the price of the securities became unhinged from their underlying index. Clients have also been burned by some leveraged and inverse products, which are designed to amplify market moves over short periods and aren’t intended for buy-and-hold investors.

The U.S. Securities and Exchange Commission is reviewing the price gyrations of the Credit Suisse product, people familiar with the matter said in March. Still, the Washington- based agency isn’t charged with measuring the suitability of exchange-traded products for small investors, a responsibility left mostly to the Financial Industry Regulatory Authority, the brokerage industry’s self-funded regulator. Finra, which faced criticism over the alleged weakness of its sanctions during the financial crisis in 2008, has since increased the penalties it imposes on member firms.

Opaque Investments

Hard-to-understand exchange-traded products, or ETPs, are one of many potentially costly choices for retail investors as they struggle to earn higher yields in a low interest-rate environment. Wall Street brokerages, insurance companies and other financial firms have pushed opaque investments including structured notes, indexed annuities, private placements and floating-rate funds to investors as a way to boost returns.

Steven Bloom, an assistant professor of economics at the U.S. Military Academy at West Point, New York, who helped invent the first U.S. ETF, said an approach based on “buyer beware” may not be good enough, especially when prospectuses and other disclosure documents are often difficult to understand, even for sophisticated investors.

“More important even than their responsibility for any one product, regulators must ensure that public trust is maintained,” Bloom said. “Capital markets are predicated on trust, and when public trust dwindles it can cast a cloud over the entire capital markets.”

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