Q and A: Should investors be worrying about their ETFs?

WASHINGTON (Reuters) - The Securities and Exchange Commission launched a broad, agency-wide review of exchange traded funds on Wednesday, and individual investors may be wondering if they should be worrying about, or avoiding, ETFs now.

The SEC unveiled its plans at a Senate subcommittee hearing amid complaints that the $1 trillion ETF industry is fueling market volatility and creating risks for small investors.

Industry leader BlackRock called for greater disclosures, and an independent think tank called for tougher regulations on the funds, typically baskets of securities like mutual funds that trade on exchanges like stocks.

(See link.reuters.com/qyr54s for more news about the hearing)

Here are the answers to five key questions investors are asking in the wake of today's meeting:

What are the basic issues being raised about ETFs?

The ETF market has grown astronomically. There are now some 1,340 ETFs, holding more than $1 trillion in assets, according to Morningstar and IndexUniverse. Along the way, they've gotten more complex. What started out as simple broad-based index funds, such as the widely held SPRD S&P 500 ETF has now expanded to include more complex products.

Some are highly leveraged and use derivative products and debt to multiply the impact of a particular market movement. Others are inverse ETFs, constructed to profit from the decline of a particular index or asset.

ETF critics have asserted that these more complex funds could harm individual investors indirectly, by creating more volatility in markets, or directly, by relying on riskier strategies that could cause shareholders to lose value. (See link.reuters.com/syr54s for more analysis)

What should I do if I already own ETFs?

Avoid the urge to panic. Most assets are in the plain vanilla stock, bond and gold ETFs, said Morningstar analyst Michael Rawson. They tend to be safe, tax efficient, easy to trade and absent the complex derivatives and trading problems that were the focus of today's hearing.

But you have to know what kind of ETF you own and how it operates, counseled Charles Rotblut of the American Association of Individual Investors. "Even similar sounding ETFs can be tracking different indexes and holding very different securities."

For example, the iShares Gold Trust and the SPDR Gold ETF both track the price of gold by physically holding gold. "You're buying a physical commodity," said Rotblut. The iPath Dow Jones-UBS Commodity Exchange Total Return ETN (DJP)invests in futures contracts. "It's easy to get the two confused if you don't understand what's comprising these funds."

Some funds track an index by buying shares of stocks in that index, he said, while others might trade in a propriety index that acts as a proxy and doesn't track its stated goal as closely. Bottom line? Understand how your ETF does what it does.

What are the risks of holding traditional ETFs?

If you trade in a thinly traded ETF, you could end up getting squeezed by a lack of liquidity. The spread between the bid and ask prices can widen and narrow, and if you're trading large sums of money, that can cost you, said Scott Burns, Morningstar's director of ETF research.

In June 2011, the North American Securities Administrators Association warned individual investors they could face termination fees and lost opportunity costs if the ETF they were invested in chose to liquidate. At that time, it said that ETFs had been liquidating at a pace of about one a week, since 2007. Of course, those were mostly smaller, more niche-oriented ETFs.

That very niche nature of some ETFs can present risks for individual investors who haven't carefully thought out their portfolio strategies. For example, there are ETFs out there that will allow investors to bet on the direction of the dollar, world uranium production or the volatility of the stock exchanges. Those ETFs are often used by professional investors to hedge other investments; they can introduce volatility and losses into an otherwise staid long-term portfolio.

What are the risks in those leveraged and inverse ETFs?

Critics like Harold Bradley of the Ewing Marion Kauffman Foundation, who testified at the Senate subcommittee hearing, suggest that some ETFs could become unstable. If too many investors are shorting a particular ETF, it could appear as if more shares are being held and passed around than actually exist. As trades in these funds settle out against each other, it could cause rapid price movements, "failed" trades and systemic failures. Burns says he's not seeing this.

"We've seen situations of massive amounts of shorting, and we don't think an ETF will collapse because of this," he said. ETF fans like Rotblut said that financial markets are more volatile now and that ETFs simply reflect that instead of making it so.

The more personal risk with those leveraged and inverse ETFs is that they can move rapidly and in a downward direction. Individual investors can get whipsawed by them. On the other hand, an ETF that is used by professional investors for arbitrage can actually provide more liquidity for individual investors, who can benefit from lower transaction costs, fees and spreads when they buy or sell such a fund, according to Burns.

Will regulators act to protect individual investors from ETFs?

The wheels of regulation grind slowly. It isn't likely that the SEC will move with any dispatch to make some ETFs off limits for mainstream investors in the way that some hedge funds are reserved for high-net-worth, sophisticated investors. The study may take a long time before any action is taken, and ETF advocates suggest a general lack of support for added regulation.

BlackRock, a major player in the traditional ETF market with some $538 billion in iShares ETF assets, has asked that the more complicated synthetically constructed funds be called something other than ETFs, to avoid confusing individual investors. The firm has also asked for more disclosure about what's exactly in ETFs.

But a flat-out ban that removes them from common trading? "That's just not the American capitalist system," said Morningstar's Rawson.

(Editing by Beth Gladstone and Ted Kerr)