July 29 (Bloomberg) -- Morgan Stanley and Wells Fargo & Co. are reviewing whether to continue sales of leveraged and inverse exchange-traded funds as regulators caution that the securities might not be suitable for individual investors.

Christine Pollak, a spokeswoman for New York-based Morgan Stanley’s brokerage joint venture with Citigroup Inc., confirmed the review in an interview today, without providing details or saying when it will be completed. Wells Fargo’s brokerage unit “will be communicating any changes with our financial advisers this week,” Teresa Dougherty, a spokeswoman for the San Francisco-based firm, said in an e-mailed statement.

The Financial Industry Regulatory Authority, the securities industry’s oversight agency, said in June that leveraged and inverse ETFs may not be appropriate for long-term investors because returns can deviate from underlying indexes when held for longer than a day. William Galvin, Massachusetts’s chief financial regulator, is investigating to make sure the products are being marketed appropriately.

“These are much more complex trading instruments than traditional ETFs,” said Ken Leon, an equity analyst at Standard & Poor’s in New York. They are mostly traded on a daily basis by institutional investors for hedging and other purposes, he said.

ETFs typically mimic indexes and, unlike conventional mutual funds, trade throughout the day like stocks. Leveraged versions use swaps or derivatives to amplify daily index returns, while the inverse funds are designed to move in the opposite direction of their benchmark.

ETF Niche

Assets in leveraged and inverse funds have increased 51 percent to $32.8 billion this year, according to data from State Street Corp., the world’s largest money manager for institutions whose products include ETFs. That’s 5.5 percent of the $593 billion in U.S.-listed ETF assets at midyear, according to data compiled by the Boston-based company.

UBS AG’s brokerage unit in New York, St. Louis-based Edward Jones and Ameriprise Financial Inc. of Minneapolis have halted sales of leveraged ETFs.

Charles Schwab Corp., the largest independent brokerage by client assets, posted a message to investors on its Web site yesterday that included the warning: “Leveraged and inverse funds have underperformed what a naïve investor might expect.”

David Weiskopf, a Schwab spokesman, said the San Francisco- based company’s representatives don’t recommend leveraged ETFs.

So-called self-directed investors “can elect to buy or sell leveraged ETFs on their own through Schwab,” he said.

Ameritrade, Fidelity

Individual investors at Bank of America Corp. have been permitted to buy leveraged and inverse ETFs from its brokerage unit since 2006 only when they specifically request them, said Selena Morris, a spokeswoman for the Charlotte, North Carolina- based company. Sales are handled by authorized advisers, she said.

TD Ameritrade Holding Corp. continues to sell the products, according to Kim Hillyer, a spokeswoman for the Omaha-based brokerage. TD Ameritrade has improved its efforts to educate individual clients about the risks, she said.

Fidelity Investments allows self-directed clients to buy the securities, Alexi Maravel, a spokesman for the Boston-based firm, said in an e-mail.

“We are aware of recent regulatory and industry discussion about these products and we are carefully following that discussion,” he said.

Barclays Wealth is reviewing the ETF issue, Monique Wise, a spokeswoman for the New York-based brokerage unit of Barclays Plc, said in an e-mail.

Direxion’s Solution

Direxion Funds has proposed a series of leveraged and inverse ETFs aimed at investors who want to hold the funds for an extended period. The Newton, Massachusetts-based company applied in February to create ETFs that track a variety of indexes over the course of a calendar month, according to a filing with the Securities and Exchange Commission.

Direxion said in the filing that certain investors would find the funds “more appropriate for their portfolios.”

Matthew Hougan, editor of Exchange-Traded Funds Report, a newsletter in Bar Harbor, Maine, said the monthly funds would create different problems for investors.

“The math in monthly ETFs is exquisitely complicated,” he said in a telephone interview.

An investor who buys one of the ETFs on the first of the month and sells it at the end of the month would get returns that track the index, Hougan said. An investor who buys mid- month may find his returns vary significantly from the underlying index.

“This is not a silver bullet,” said Hougan.

Carol Graumann, a spokeswoman for Direxion, didn’t immediately return a telephone call seeking comment.

Direxion managed $5 billion in ETFs at the end of June, according to data from State Street.

To contact the reporters on this story: Christopher Condon in Boston at ccondon4@bloomberg.net; Charles Stein in Boston at cstein4@bloomberg.net

Last Updated: July 29, 2009 16:34 EDT