Inverse ETFs and other mutal funds investing in derivatives may put investors at undue risk.
Regulators with the U.S. Securities and Exchange Commission (SEC) remain concerned about the use of derivatives in inverse ETFs and other types of mutual funds.
The SEC is currently seeking comments on a wide range of issues concerning inverse ETFs and other types of mutual funds that invest in controversial derivative products. The comments will help guide the commission as it evaluates whether the funds pose unacceptable risks to investors. The review is in keeping with the requirements of the Investment Company Act of 1940, which regulates exchange-traded funds and other types of mutual funds.
More than $13.1 trillion assets were managed by mutual funds at the end of 2010, said the SEC, and these funds were owned by more than 40 percent of U.S. households. According to the website etf.com, exchange-traded funds account for roughly 10 percent of the mutual fund market share. The funds growing popularity is attributed to relatively low fees and liquidity, and ability to efficiently diversify a portfolio.
Well educated investors at the highest wealth levels are most likely to invest in ETFs. A December survey by Millionaire Corner shows that 40 percent of investors with $5 million to $25 million have invested in ETFs. The share drops to 29 percent for investors with $1 million to $5 million, and to 11 percent for investors with $100,000 up to $1 million.
The funds, which now number about 2,000, have also caught the eye of regulators and industry experts who have expressed concerns over inverse etfs, exchange-traded funds wrapped around a derivative product. The SEC explains that these “leveraged” ETFs are index-based funds that use derivative products to deliver multiples or inverse multiples of the index performance. Derivatives are a financial tool with value tied to an underlying product, such as futures. Most involve leverage.
The SEC is reviewing how to measure the degree of indebtedness a fund incurs when it invests in a derivative and how to evaluate the degree of diversification funds invested in derivatives offer. The SEC is also examining how funds invested in derivatives determine and report the value of their assets.
Industry experts also raise concerns about structural flaws with exchange-traded funds. During the Flash Crash of May 6, 2010, ETFs accounted for 70 percent of cancelled trades, while only 11 percent of listed securities involve ETFs, Andrew Bogan, managing member of Boston-based Bogan Associates, LLC, told Zero Hedge.
“From the perspective of financial theory, that makes absolutely no sense,” said Bogan. “ETFs are meant to be index-fund trackers. They’re meant to represent a whole basket of shares, and yet these very securities that are meant to be diversified actually fell more than their underlying stocks during the Flash Crash, more often and more deeply.”