April 26, 2012 / 9:06 PM / 6 years ago

ETF providers worry about taint from exotic products

* Firms worry they will be lumped in with exotic ETFs

* 40 pct of European EFT assets are synthetic

By Jessica Toonkel

NEW YORK, April 26 (Reuters) - As European and U.S. regulators step up their focus on complex exchange-traded products, companies that offer exchange-traded funds are worried that investors will confuse their products with the ones under scrutiny.

Along with the rapid growth of the global $1.7 trillion ETF market, some of the product offerings have become more complex. Exotic offerings that do not invest in underlying securities -- like synthetic ETFs in Europe and exchange-traded notes (ETNs) in the United States -- have raised concerns among regulators that investors do may not understand what they are buying.

The problem is more acute in Europe, where 40 percent of all ETF assets are synthetic.

In turn, companies in the United States that offer more traditional exchange-traded funds -- which are registered under the 1940 Investment Act and are regulated like open-end mutual funds -- are worried investors may lump their products with their more complex and controversial cousins and avoid them altogether.

“We may not be perfect, but in the (exchange-traded product) game we are by far the best game in town,” said Jonathan Steinberg, chief executive of WisdomTree, at a NYSE Euronext press event Thursday.

In Europe, ETFs have become controversial because many are “synthetic,” meaning they do not actually own underlying securities and instead use derivatives to replicate returns. In Europe, about 40 percent of ETF assets are in “synthetic products,” according to BlackRock Inc.

Europe’s market watchdog, the European Securities and Markets Authority, has proposed mandating that ETF providers offer greater disclosure about how they operate.

This controversy has caused a headache for U.S. ETF providers, the majority of which do not offer synthetic ETFs, said Noah Hamman, chief executive and president of AdvisorShares, at the NYSE event.

“I am more concerned that ... people are looking at European exchange traded products and applying it to the U.S.,” Hamman said. “We spend some amount of time educating people on this.”

U.S. ETFs have their own issues. Regulators have said they are taking a closer look at leveraged and inverse ETFs, which are designed to amplify short-term returns by using debt and derivatives, and are more suitable for professional traders than for long-term retail investors.

At the same time, recent swings in an exchange-traded note that makes bets on market volatility have drawn the attention of the U.S. Securities and Exchange Commission, the Financial Industry Regulatory Authority and the Massachusetts attorney general.

The focus on ETNs came after the Credit Suisse-managed VelocityShares Daily 2x Short-Term TVIX.K ETN lost half its value in just two days earlier last month.

ETNs and ETFs are often lumped together by investors and the media, but ETNs differ from ETFs in that they are not portfolios of investments. Instead, ETNs are contracts in which the issuers agree to pay investors returns that are equal to the investments they aim to track.

A panel of three ETF providers and one expert at the Capital Link Annual Closed-End Funds and Global ETFs Forum Tuesday in New York all mentioned investor confusion over all these different products as one of their biggest concerns.

Among them: Alex Depetris, vice president in the db-X Group of Deutsche Bank, which offers commodity and currency-based ETFs as well as exchange-traded notes, said “investor understanding of the different products” was his biggest concern.

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