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ETF Specialist

Time for Derivative ETFs to Comply

Exchange-traded funds using derivatives should comply to the same standards as derivatives.

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Financial innovation always has unintended consequences. As good as an idea may be for some investors, the suitability of that idea may not always carry for the majority. This is especially true when you consider the individual investor and the occasional need to protect them--and their assets--from products that they do not understand.

In the beginning, ETFs were fairly straightforward products. Investors bought a fund--whether it was a broad basket, a specific sector, or even a single country--and they more or less understood what they were getting into. Investors could see the holdings and the returns that they experienced were usually in line with their expectations. That is, the odds of an investor having an unexpected adverse investing experience was minimal. If large-cap stocks rose during the week, the S&P-500-tracking  SPDRs (SPY) was up for the week.

In the latest wave of financial innovation, we have seen an explosion of ETF products that are, in essence, "exchange-traded derivative funds." These funds use baskets of derivatives to provide inverse, leveraged, leveraged-inverse, and commodity-linked returns. Many other industry observers have taken to calling these "exchange-traded products," but we would like to take it a step further and call them what they are: exchange-traded derivative funds (ETDFs).

Regardless of what they are called, the industry as a whole has recognized that these special funds should not be confused with more-vanilla ETFs holding stocks, bonds, or physical assets. The desire to avoid this confusion is justified in the differences not just of the underlying holdings, but also in the complexity inherent to these funds in terms of structure, use, and even taxation. Ultimately, because of this complexity, the possibility for the average investor to suffer an adverse investing experience has increased tremendously.

We covered the complexities of these funds in detail in our report "Warning: Leveraged ETFs Kill Portfolios," in a video on "How to Pick the Right Oil Fund," and in our article "Your ETF Tax Questions Answered." Educating investors and advisors on the complexities of these products has been our number-one goal for 2009. One theme has remained consistent for us in our coverage of these funds. By themselves, there is nothing inherently wrong with these products. There is, however, something terribly wrong with misusing them and allowing them to be misused.

Individuals and ETDFs
As strange as it may seem, the IRS has led the way in showing us how we should deal with ETFs. For taxation purposes, the IRS looks through an ETF "wrapper" and dictates that if the fund holds stocks, it is taxed like a stock, and if the fund holds bonds, it is taxed like a bond. It even looks through exchange-traded derivative funds, recognizes that these are made up of derivatives, and taxes them as it would similar derivatives.

Following the IRS' lead, these funds should be held to the same approval standards that we apply to their underlying holdings. In any trading or brokerage account, you must be approved to purchase options and other derivatives. Getting approval is actually fairly simple. As far as I can tell, you basically need to read (or at least acknowledge that you read) a 216-page overview of how options work and the risks associated with options. After that, there is some more legal acknowledgement of risk and testimony on the investor's part that he has some idea as to what he is doing.

We propose that, similar to options, investors who want to utilize exchange-traded derivative products would need to also get similar approval to buy these funds in their accounts and that the industry would put together a joint document explaining how these funds work and detailing the risks associated with these products.

It may not seem like much, but that simple step would go a long way toward keeping people who don't truly understand the function and use of these funds from investing in them. Those that do seek and get approval, well, it is the rule of caveat emptor for them, and we wish them good luck.

Financial Advisors and ETDFs
To me, what's even more dangerous than individual investors having unfettered access to these products is that the financial-advisor community can also use these products without any disclosure. These products have allowed derivatives and leverage a backdoor entrance into people's portfolios without them having any knowledge of it. I speak at quite a few advisor conferences, and it never fails that when the topic of leveraged ETFs comes up--and it always does--there is someone in the room who has no idea that they only provide daily leverage and who is similarly unaware of the issues resulting from holding these funds for the long term. Sometimes it is a handful of people in the room, sometimes it is half the room. Either way, I am appalled that it is any of them.

Do I have any figures on how many financial advisors don't understand these products and are using them in clients' portfolios? I do not, but I don't think that I really need that data. Even one advisor using these products incorrectly would be one too many. Who is to blame for using these incorrectly? The advisor is, of course, to blame. Who is hurt by the advisor doing this? The innocent person who trusted the advisor in the first place, and that is where safeguards need to be installed.

The remedy is again quite simple: Treat these funds as advisors would treat buying and selling individual derivatives in their clients' portfolios. That means that the same suitability standards should apply as well as the same standards of disclosure. There's no reason that advisors should be allowed to backdoor leveraged positions, short positions, or the complexities of futures positions into their clients' portfolios as is currently the case with these funds.  

Of course, the Securities and Exchange Commission is the ultimate decider on how ETDFs will be fit into its overall compliance scheme. Even so, I call on organizations such as the National Association of Personal Financial Advisors (NAPFA), the National Association of Insurance and Financial Advisors (NAIFA), and, most importantly, the Financial Industry Regulatory Authority (FINRA) to educate their members on these products and hold their members to the same standards to which they hold them regarding individual derivative securities. That includes updating the testing materials for securities brokerage licenses such as the Series 7 and Series 63 tests to address these products. It also includes updating the course material and tests for certifications such as the Certified Financial Planner (CFP) designation.


Commodity ETDFs
As with innovation, regulation and increased compliance always have their own unintended consequences. We argued as a team quite a bit about what we would recommend for ETDFs that tracked commodities. On one hand, we hail the democratization that these products have brought to investors and advisors. We think that a diversified commodities stake is a key part of any asset-allocation portfolio. We think that people should be able to invest or speculate in single commodities if that is what they truly want to do--as long as they understand what they are doing.

Although these ETDFs do not possess the same inherent risk of leverage and daily compounding that leveraged ETF products do, they do have return profiles that fall outside of the expectations of the average investor. For example, a common misperception would be that if you purchased  United States Oil (USO), the returns would track those of the spot price of oil, which is often quoted in the financial press. Not to pick on USO, but folks who purchased that fund earlier this year have been shocked that as the price of oil soared, the return of USO was relatively flat. This, of course, happened because many investors didn't understand how the fund was structured to begin with.

The lack of understanding derives mainly from investors who thought that they were buying commodities at "spot" prices, but were in actuality buying forwards and futures contracts on that commodity. These derivatives can go into contango or its inverses, backwardation, causing the returns of the fund to deviate, sometimes substantially, from that of spot prices. Contango isn't something that a person comes across everyday. In fact, why it happens and what it means for your investment are actually pretty complicated subjects that the average investor isn't going to understand without substantial education. In addition to that, how these funds are taxed caught many investors by surprise.

In our internal debate, the fact that most commodity-themed ETDFs don't have the same leverage profile as some of the other ETDFs was a mitigating factor. Still, the level of sophistication required to properly invest in these funds and understand their risks is greater than what the average retail investor should be expected to know. In terms of single-commodity funds, we think that they should fall under the same rules that we proposed for other ETDFs.

However, we feel that there is a drawback from keeping investors and advisors out of the broad-basket commodity indexes. We think that these serve a valuable purpose in asset allocation for investors and advisors alike. Even worse, their best comparables, exchange-traded notes, have their own complicated issues because of their inherent credit risk. Ideally, we would like to seek some sort of exception made for the broad-basket funds, but we are not sure that is feasible.

Market Impact of ETDF Compliance
The reality is that the market impact of this should be negligible to the sponsors of these funds. I've sat on a panel with two of the largest providers of ETDFs, and they have flat-out said that these funds are designed for sophisticated investors and that there are risks to using these funds inappropriately. Good, we are all in agreement then.

They have also trotted out that judging by the trading volumes--in the billions of dollars on a daily basis--institutions by and large are the ones using these funds. Not that I have any data to back it up, but common sense will tell you that the daily trading of 10 large hedge funds could easily mask the trading of tens of thousands of individuals and advisors--especially if they are holding the funds and not trading them. After all, it is protecting these less-sophisticated investors that is the point of all this.

In all fairness, the providers of ETDFs have been very upfront about the proper uses and risks of these products in their prospectuses and in their client-support material. I know that we have tried to educate people on these products as have other ETF analysts and observers. Unfortunately, I don't know if we could ever do enough education to prevent someone from unwittingly using these products incorrectly.

Others in the media have gone so far as to say that we should ban ETDFs entirely. It should be clear that we are not advocating that by any means. There is nothing inherently evil about these products. They are useful and suitable tools for many institutional and sophisticated investors. Our goal is to keep the uninitiated from being allowed to blindly invest in them without deep understanding of the risks and appropriate uses.

My hope is that the providers and the rest of the industry will join me in this call for increased compliance and trading approvals for these funds. If they are geared toward institutions, then this won't really impact the providers at all. If you are an individual or an advisor sophisticated enough to understand and use these products, then you probably already have an option-approved account, so this won't mean a thing to you either. For the rest of the world, it will keep people from inadvertently stumbling into a product they don't understand. 


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Disclosure: Morningstar licenses its indexes to certain ETF and ETN providers, including Barclays Global Investors (BGI), First Trust, and ELEMENTS, for use in exchange-traded funds and notes. These ETFs and ETNs are not sponsored, issued, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in ETFs or ETNs that are based on Morningstar indexes.

Scott Burns does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.