Hedge Fund ETF weapons turn dangerous for smaller investors

ETFs vs. ETNs

ETPs were the fastest-growing major investment product over the past decade, as investors embraced their simplicity, tax efficiency and low cost. Assets in the U.S. increased almost 14- fold in the 10 years through April 30 to $1.19 trillion, according to the Investment Company Institute. U.S. investors added $4.82 to exchange-traded products last year for every $1 they deposited with mutual funds.

Those same investors can choose from more than 1,400 ETPs, a term that includes funds, trusts and unsecured notes, according to data compiled by Bloomberg. Exchange-traded notes, the equivalent of bonds, are unique among ETPs in that they aren’t backed by a pool of holdings owned by shareholders. They represent merely a promise to pay a return, defined typically by an index.

Derivative-based ETPs and ETNs have swelled since they were introduced in 2006 to $58.8 billion, accounting for 4.9 percent of ETP assets in the U.S. The SEC in 2010 stopped approving new funds, including ETFs, that make significant use of derivatives, pending a review. The suspension doesn’t affect products such as ETNs that aren’t registered under the 1940 Investment Company Act.

Array of Products

Investors have a dizzying array of funds to choose from. Apart from funds that track broad indexes such as the Standard & Poor’s 500, there are those that buy Asian junk bonds and global agriculture stocks; trusts that track groups of hedge funds and the Swedish krona. There is even a note from the Royal Bank of Scotland that, according to the product’s description, “utilizes a systematic trend-following strategy to provide exposure to either the BNY Mellon China Select ADR Total Return Index or the yield on a hypothetical notional investment in three-month U.S. Treasury bills.”

Even companies that sell ETPs are pushing for better disclosure. New York-based BlackRock Inc., the biggest provider of ETPs, has proposed that regulators enforce a new categorization regime with clearer labeling and risk disclosures to aid retail buyers. CEO Laurence D. Fink compared the development of hard-to-understand ETPs to financial engineering in the mortgage-backed securities market, which played a key role in the 2008 financial crisis.

Systemic Risks

As it tries to keep up with the market, the SEC has hired new staffers with ETP expertise, including Barry Pershkow, former counsel at ProShare Advisors LLC, a provider of leveraged and inverse ETFs. In October, Eileen Rominger, head of the agency’s investment-management division, said the SEC was conducting a “general review of ETPs” that included an examination of investor disclosure.

Rominger said the SEC was also looking at whether ETPs, as a group, represented any systemic risks, examining their contribution to equity-market volatility in 2010 and the 8.6 percent intraday plunge in the Standard & Poor’s 500 Index on May 6, 2010.

Since those events, Morningstar analyst Michael Rawson and Federal Reserve Bank of Cleveland analyst Emre Ergungor have published research discounting the product’s impact on volatility and the 2010 stock-market rout, respectively.

SEC Role

SEC spokesman John Nester declined to comment on the agency’s inquiries or how it examines exchange-traded products on their way to market.

The SEC’s role in approving a new product depends on its type. The agency reviews registration statements of the shares or notes issued by all ETPs to make sure they meet disclosure requirements related to the securities and the issuer. Funds registering as investment companies are subject to additional reporting requirements and disclosures connected to investment objectives, risks and expenses.

What the approval process doesn’t include is a judgment on whether the product is any good, or who should use it.

“The SEC and federal securities laws don’t take a merit- based approach to regulation,” said Mercer Bullard, an associate professor of law at the University of Mississippi and founder of the advocacy group Fund Democracy Inc.

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