August 14, 2012 6:16 pm

Fresh warning on leveraged ETFs

US regulators have issued a fresh warning that leveraged exchange traded funds are not suitable for long term investors.

In an bulletin to educate investors about ETFs, the Securities and Exchange Commission’s Office of Investor Education and Advocacy said leveraged ETFs were potentially unsuitable for long term investors because they achieve their investment objective on a daily basis only.

The SEC’s bulletin said that while some ETFs were relatively easy to understand, others could have unusual investment objectives or use complex investment strategies that might be difficult to understand.

“Do not invest in something that you do not understand. If you cannot explain the investment opportunity in a few words and in an understandable way, you may need to reconsider the potential investment,” said the SEC.

Warnings from US regulators about the suitability of leveraged ETFs are not new. The SEC first expressed its concerns about leveraged and inverse ETFs in an alert in August 2009.

The SEC has also been conducting a review of derivative based funds, including leveraged and actively managed ETFs, to determine whether “additional protections” are required.

While the review is continuing, the SEC has halted the launch of any new ETFs that would make significant investments in derivatives, although existing products are not affected.

But providers have still been able to find a route to market by launching new leveraged and inverse products under the 1933 Securities Act. The restrictions imposed by the SEC only apply to exchange traded funds registered under the 1940 Investment Company Act.

Providers of leveraged and inverse ETFs also routinely emphasise that their products are intended as short term trading instruments and not as long term investments.

But US regulators have been getting tougher on leveraged and inverse ETFs. In May, the Financial Industry Regulatory Authority (Finra) fined four US brokers (Citigroup, Morgan Stanley, UBS Financial Services and Wells Fargo Advisors) more than $9.1m for selling leveraged and inverse ETFs without reasonable supervision.

The consistently critical tone of regulators towards leveraged and inverse ETFs may be having an impact on new inflows which have declined substantially this year, shrinking to just over $1.5bn in the first seven months of 2012 compared with $5.5bn in the same period a year ago, according to ETFGI, the consultancy.

Analysts also suggest that demand for leveraged and inverse ETF’s for hedging purposes has declined because equity market volatility has remained extremely subdued this year.

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