Wednesday, December 19, 2012

Derivatives in Active ETFs

By Tim Husson, PhD

Over two and a half years ago, the SEC initiated a moratorium on approvals for new ETFs that made extensive use of derivatives such as options and futures contracts. Much of the concern at that time was that derivatives-based ETFs, particularly leveraged, inverse, and futures-based ETFs may not have investor protections or oversight commensurate with their level of risk. Regular readers of this blog know that we have spent a good deal of time discussing those issues in addition to our research work on the subject.

As reported by Brendan Conway at Barron's as well as IndexUniverse, the SEC will allow more lax regulation of the use of derivatives in actively-managed ETFs. The key word here is actively-managed--typical leveraged, inverse, and futures-based ETFs are actually structured as passively managed funds, which is to say they follow a predefined strategy and target a specific index to track (before fees). Actively-managed ETFs are different in that they rely on the judgment of a fund manager, and have only recently become common in the ETF space.

So in some sense, the SEC's announcement does not address the primary concerns that led to the 2010 moratorium. In the meantime, the two main issuers of leveraged and inverse ETFs in the US (ProShares and Direxion) have enjoyed an effective duopoly, as noted by Brendan Conway:
It’s funny how the policy has worked. The makers of popular plain-vanilla ETFs often face five, six or more direct competitors. The crowding of new products has been a good thing for investors. But ProShares and Direxion essentially have the leveraged ETF market — so distrusted by regulators — to themselves. Which isn’t good for competition or choice.
Indeed, the SEC will not be lifting the moratorium for leveraged ETFs in the near future.

But there is an even larger issue here. ETFs can be purchased quickly and easily by almost any retail investor. If ETFs have complex embedded derivatives positions, positions that would be unsuitable for unsophisticated investors if purchased directly, are the ETFs themselves suitable? The answer is likely complex, as mutual funds and other more traditional investments make use of derivatives for many risk-management purposes. But the use of derivatives can also be used to create positions that retail investors and brokers may not understand or use properly, and it is still not clear what kind of regulation will prevent those types of investments from finding their way into retirement and other conservative portfolios.

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