Watchdogs coming up short on ETF risks

April 26, 2012

By Agnes T. Crane
The author is a Reuters Breakingviews columnist. The opinions expressed are her own.Watchdogs are still coming up short on dealing with the risks of exchange-traded funds. It’s heartening to see one of them, the Financial Industry Regulatory Authority, going after brokers for mis-selling complicated variants of ETFs. But investors need more protection earlier on in the process.

Most of the $1.7 trillion ETF market remains relatively straightforward. They offer a simple solution to a simple problem, allowing retail investors who just want index returns a vehicle that can be traded just like any other stock.

But not all ETFs are created equal. Their overwhelming popularity over the past decade has spawned a host of newer products that are neither simple nor safe – some are high-stakes trading vehicles designed to be bought and sold on the same day, for example. But it’s not always obvious. Some ETF managers like BlackRock are pushing for better disclosures. But brokers aren’t always much help.

The ones Finra has in its sights, for example, allegedly sold leveraged and inverse ETFs to mom-and-pop investors interested in long-term investments. That’s akin to giving a circular saw to a toddler. These short-term, structured ETFs can make mincemeat of an unwitting buyer’s investment portfolio.

Retail investors should also be wary of exchange-traded notes. These are a distant cousin of the ETF and are, in fact, uncollateralized bank debt. So if the issuing lender goes bust, bye-bye ETN. And unlike ETFs these vehicles aren’t covered by the Investment Company Act of 1940. That means there are no standard disclosure requirements or a board of directors with a fiduciary responsibility to investors. That has led to a proliferation of hidden fees in novel-length prospectuses that can exceed 300 pages.

ETNs and complex ETFs may only account for around $50 billion of the exchange-traded universe. But they are growing. Regulators are certainly aware of some of the potential pitfalls, as the Finra case shows. But reacting after the event should not be the first option. Even something as simple as requiring a health warning on the front page of the prospectus for riskier ETFs would be a start. But without a broader overhaul of the rules to require that managers and brokers vastly improve disclosure on the financial exposures and investment aims of riskier vehicles, as well as their fees and other costs, there are likely to be more accusations of ETF wrongdoing in the future.

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