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SEC Raises Red Flags On Leveraged ETFs

Olly Ludwig

Certain types of ETFs, particularly those that serve up inverse and leveraged strategies, may be more difficult for investors to understand than typical straight equity-type securities—a fact that led the Securities and Exchange Commission to issue a bulletin outlining the risks of ETFs.

"Certain ETFs can be relatively easy to understand. Other ETFs may have unusual investment objectives or use complex investment strategies that may be more difficult to understand and fit into an investor’s investment portfolio,” the SEC's Office of Investor Education and Advocacy said in the bulletin.

Again, the commission singled out those ETFs that serve up double the exposure of a given index or its inverse. The problem with many such securities is that they rebalance daily, making their returns diverge dramatically from their indexes.

"These ETFs seek to achieve their investment objective on a daily basis only, potentially making them unsuitable for long-term investors,” the SEC said in the bulletin, which echoed a similar warning about leveraged and inverse funds in 2009 made by the Financial Regulatory Authority.

Plain-vanilla ETFs are quite like mutual funds, except that ETFs are priced on an intraday basis, while mutual funds are priced at the end of each trading day.

The SEC's bulletin comes in an era when ETFs are becoming increasingly popular--in part because they are less expensive to own and often more tax efficient than competing mutual funds. The commission cited the creation and redemption mechanism that is at the center of every ETF as one of the reasons investors are shielded from taxes at the fund level.

In a related vein, the SEC's more-than-two-year-old inquiry into the use of derivatives in actively managed or leveraged and inverse funds remains incomplete. In March 2010, the commission said it wouldn't approve any new or pending petitions from fund sponsors who were looking to market active or leverage and inverse funds that contemplated the use of derivatives in their investment strategies.

A Growing Industry

A total of more than $1.2 trillion is now invested in ETFs after the first exchange-traded fund, the SPDR S'P 500 ETF (SPY) was rolled out in January 1993.

The vast majority of ETFs are passively managed funds designed to track indexes comprising stocks, bonds, commodities and other asset classes, but actively managed ETFs are becoming more common. The growing presence of actively managed ETFs adds another layer of complexity investors need to be mindful of.

“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,” the SEC bulletin said.

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