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SEC Misses the Bull's-Eye with Derivative ETFs

Shotgun blast hits the target, but unintended consequences may hamper investors in the end.

Scott Burns, 04/05/2010

The SEC's March 25 decision to defer the review of any new exemptive relief filings that made heavy use of derivatives sent ripples through the fund industry. Particularly named were active and leveraged strategies. The SEC stated that this was part and parcel of an ongoing review of the use of derivatives in mutual funds, exchange-traded funds, and closed-end funds (the collective known as " '40 act funds" for the Investment Company Act of 1940 that governs these securities.)

The furor in the fund industry over this announcement grew so loud that the usually reserved SEC needed to make clarifying statements to try to calm things down. Unfortunately, as far as I can tell, the clarification only reiterated what the announcement said, so there are still plenty of unanswered questions.

A feature by Ignites (registration required) provided the excerpt of explanation from SEC spokespersons:

"(Elizabeth) Osterman also makes clear that the exemptive application process for actively managed ETF products that propose using significant amounts of derivatives 'can move forward' as long as the funds agree to restrict the use of certain derivatives. Specifically, the SEC is willing to proceed as long as actively managed, fully transparent ETFs represent that they will not invest in futures, swaps, and options, according to an agency spokesman, John Heine."

What does this mean? You can use derivatives, as long as you don't use derivatives? The only thing missing from the listed types of derivatives are forwards and swaptions--and I'm not really sure those were meant to be left off the list. Now, this could be a case of combining two different quotes from two people, but the result is clearly in conflict, and the confusion is mounting not decreasing.

Still, the SEC's decision to review the use of derivatives in terms of how leverage has been employed and disclosed and how the underlying collateral and counterparty risks have been reported couldn't be more on target. Given recent problems in the financial industry, bringing transparency to these issues is of the utmost importance. That is true regardless of whether or not the fund in question is a mutual fund, ETF, or closed-end fund. It is becoming nearly impossible for an investor to understand the notional exposure and risks associated with some of the largest mutual funds and most heavily traded ETFs, and that cannot stand.

While on target with the review of these crucial issues, there are some unintended consequences to this scattershot decision. There are several areas in the ETF space that would benefit greatly from the marriage of active management and derivatives.

Active Commodity ETFs
First up is the area that is most in need of active management involving derivative strategies. There is a real problem right now with many of the passive commodity futures tracking strategies regarding their inability to move away from adverse changes in the futures curve. This is the dreaded "Contango Problem" that has plagued popular funds such as United States Oil USO. It is obvious that investors are looking for an ETF that will give them exposure to the price movements of commodities but are currently stuck with a slew of imperfect passive offerings that are getting killed by contango. An active manager would presumably be able to mitigate this problem by being able to purchase the most favorable part of the yield curve, while avoiding the traps of passive strategies.

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