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ETF News

Regulators eye exotic ETFs in information sweep

* Finra seeks details on sales, marketing of levered ETFs

* Focus is on one-day investment horizon of ‘exotic’ ETFs

* Sale to unsophisticated investor on Finra’ radar screen

* ProFunds defends ETFs’ use, plans education campaign

By Herbert Lash

NEW YORK, July 2 (Reuters) - A battle is brewing over leveraged exchange-traded funds, a derivatives cocktail whose growing popularity some say was at the center of sharp market volatility after the collapse of Lehman Brothers in September.

The Financial Industry Regulatory Authority recently conducted an information sweep of U.S. firms that sell the non-traditional ETFs, seeking a host of details about their sales to investors with accounts smaller than $10 million.

Finra, the industry’s own watchdog, targeted ETFs that use leverage and aim to provide double or triple the return of an index, or its inverse performance, and that were held for more than 10 days.

Finra issued Regulatory Notice 09-31 on June 11 to remind brokers that any security they offer must be suitable for their customers. The performance of some of the ETFs in question suggests their returns can differ greatly over longer periods than their stated investment horizon of a single day, it said.

Finra said the non-traditional ETFs “typically are not suitable for retail investors who plan to hold them for more than one trading session, particularly in volatile markets.”

The one-day profile of these ETFs lies at the heart of a potential fight over their use by retail investors, who along with institutional investors helped make an ETF offered by Direxion Funds the No. 4 best-selling U.S. fund in May, data from Financial Research Corp show.

ProFunds, the leading provider of non-traditional ETFs, agreed with Finra that leveraged ETFs may not be suitable for certain investors. But it disputes that they are one-day only investments, and plans to roll out an education program for both retail investors and the brokers who sell them.

Unlike other ETFs, which invest in a sector or group of stocks, non-traditional ETFs routinely include futures, options on futures, forward contracts and swap agreements. ProFunds has termed these instruments, among others employed, “aggressive.”

“We actually support the Finra notice, except for one piece of it, we’re very supportive of the effort to educate,” Michael Sapir, chairman and chief executive of ProFunds, told Reuters in an interview.

“For unsophisticated investors, these are not products ... they should be using,” Sapir said. He added later: “Don’t buy it unless you understand it.”

Finra’s request for information concluded June 12 but the regulator is still analyzing the data, said spokesman Herb Perone, who called the ETFs in question “exotic,” and “extremely complicated and confusing products.”

In an e-mail, Perone said, “The marketing and sale of these products to unsophisticated retail investors is very much on Finra’s radar screen.”

ETFs have exploded in growth in recent years. Investments in ProFunds’ non-traditional ETFs surged to $27.5 billion in June from zero just three years.

DID LEVERAGED ETFS CONTRIBUTE TO MARKET PLUNGE?

Their enormous popularity, and the pummeling that stocks took after Lehman went bankrupt in September, has led some investors to question whether the leveraged ETFs contributed to the stock market’s steep plunge from late September through March.

A May report by Barclays Global Investors said that the daily rebalancing of levered ETFs exacerbated the volatility of underlying indexes and securities that comprise the indexes.

The U.S. Securities and Exchange Commission received 221 letters critical of the leveraged ETFs after it recently sought comment on how to address short-selling.

Sapir called the perceived role of ETFs in the steep sell-off unfounded market “lore.” He doesn’t expect possible new SEC rules on short-selling to “materially affect” business. Short-selling is a bet that a security’s price will decline.

“What’s been lost in this conversation is that we are a small, little piece overall,” Sapir said, pointing to other short-selling instruments available to investors.

Sapir said from Sept. 30 to March 9 -- the bear market’s low -- ProFunds’ net exposure to stocks was long $1.9 billion, rebutting critics who have said the exotic ETFs put downward pressure on the overall stock market.

Sapir also took issue with Finra’s determination that the non-traditional ETFs are unsuitable for retail investors who hold them for long periods.

“The empirical data is significantly inconsistent with that notion,” he said.

An internal ProFunds study of rolling periods over the past 50 years concluded that the impact of compounding during a 91-day span or less was virtually zero, and over half-year and full-year periods the impact was 0.7 percent or less.

Finra provided two examples in its June notice of ETFs whose performance from Dec. 1 to April 30 could have produced steep losses if held throughout that period. The returns varied greatly from the index or benchmark they aimed to track.

The fact few investors understand what comprises the exotic ETFs and that too many retail investors hold them beyond one day make them dubious, said Joe Saluzzi, co-manager of trading at Themis Trading in Chatham, New Jersey.

“It’s nice of them to wake up finally,” Saluzzi said about Finra’s sweep. “Maybe the SEC should stop approving these damn things, that would be a start.” (Additional reporting by Jonathan Spicer; Editing by Leslie Adler)

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