If you are convinced, really convinced, the price of crude oil will rise today and U.S. stocks will fall, Factor Advisors LLC has an exchange-traded fund for you.
The FactorShares 2X: Oil Bull/S&P500 Bear offered by the New York-based firm makes a two-times long wager on crude oil futures and a short bet on Standard & Poor’s 500 Index futures, in effect delivering twice the daily change in the spread between the two positions. The product’s birth followed “a lot of feedback” from institutional investors, including hedge funds, Stuart Rosenthal, chief executive officer of Factor Advisors, said in a telephone interview.
As the biggest ETF managers capture assets from traditional mutual funds with benchmark-tracking offerings, smaller competitors are catering to sophisticated investors with an increasingly complex arsenal of products. Often based on derivatives, these can be weapons for savvy investors to amplify wagers on rising or falling prices of everything from stocks and bonds to currencies and commodities. The same tools, readily available through conventional and online brokers, have proven hazardous for individual investors who sometimes misunderstand and misuse them with costly consequences.
“If you make it available to the masses, watch out, because the masses might buy them,” Paul Justice, an analyst with Chicago-based fund researcher Morningstar Inc., said in a telephone interview.
Earlier this year, notes issued by Credit Suisse AG lost half their value in two days as the price of the securities became unhinged from their underlying index. Clients have also been burned by some leveraged and inverse products, which are designed to amplify market moves over short periods and aren’t intended for buy-and-hold investors.
The U.S. Securities and Exchange Commission is reviewing the price gyrations of the Credit Suisse product, people familiar with the matter said in March. Still, the Washington-based agency isn’t charged with measuring the suitability of exchange-traded products for small investors, a responsibility left mostly to the Financial Industry Regulatory Authority, the brokerage industry’s self-funded regulator. Finra, which faced criticism over the alleged weakness of its sanctions during the financial crisis in 2008, has since increased the penalties it imposes on member firms.
Hard-to-understand exchange-traded products, or ETPs, are one of many potentially costly choices for retail investors as they struggle to earn higher yields in a low interest-rate environment. Wall Street brokerages, insurance companies and other financial firms have pushed opaque investments including structured notes, indexed annuities, private placements and floating-rate funds to investors as a way to boost returns.
Steven Bloom, an assistant professor of economics at the U.S. Military Academy at West Point, New York, who helped invent the first U.S. ETF, said an approach based on “buyer beware” may not be good enough, especially when prospectuses and other disclosure documents are often difficult to understand, even for sophisticated investors.
“More important even than their responsibility for any one product, regulators must ensure that public trust is maintained,” Bloom said. “Capital markets are predicated on trust, and when public trust dwindles it can cast a cloud over the entire capital markets.”
ETFs vs. ETNs
ETPs were the fastest-growing major investment product over the past decade, as investors embraced their simplicity, tax efficiency and low cost. Assets in the U.S. increased almost 14-fold in the 10 years through April 30 to $1.19 trillion, according to the Investment Company Institute. U.S. investors added $4.82 to exchange-traded products last year for every $1 they deposited with mutual funds.
Those same investors can choose from more than 1,400 ETPs, a term that includes funds, trusts and unsecured notes, according to data compiled by Bloomberg. Exchange-traded notes, the equivalent of bonds, are unique among ETPs in that they aren’t backed by a pool of holdings owned by shareholders. They represent merely a promise to pay a return, defined typically by an index.
Derivative-based ETPs and ETNs have swelled since they were introduced in 2006 to $58.8 billion, accounting for 4.9 percent of ETP assets in the U.S. The SEC in 2010 stopped approving new funds, including ETFs, that make significant use of derivatives, pending a review. The suspension doesn’t affect products such as ETNs that aren’t registered under the 1940 Investment Company Act.
Array of Products
Investors have a dizzying array of funds to choose from. Apart from funds that track broad indexes such as the Standard & Poor’s 500, there are those that buy Asian junk bonds and global agriculture stocks; trusts that track groups of hedge funds and the Swedish krona. There is even a note from the Royal Bank of Scotland that, according to the product’s description, “utilizes a systematic trend-following strategy to provide exposure to either the BNY Mellon China Select ADR Total Return Index or the yield on a hypothetical notional investment in three-month U.S. Treasury bills.”
Even companies that sell ETPs are pushing for better disclosure. New York-based BlackRock Inc., the biggest provider of ETPs, has proposed that regulators enforce a new categorization regime with clearer labeling and risk disclosures to aid retail buyers. CEO Laurence D. Fink compared the development of hard-to-understand ETPs to financial engineering in the mortgage-backed securities market, which played a key role in the 2008 financial crisis.
As it tries to keep up with the market, the SEC has hired new staffers with ETP expertise, including Barry Pershkow, former counsel at ProShare Advisors LLC, a provider of leveraged and inverse ETFs. In October, Eileen Rominger, head of the agency’s investment-management division, said the SEC was conducting a “general review of ETPs” that included an examination of investor disclosure.
Rominger said the SEC was also looking at whether ETPs, as a group, represented any systemic risks, examining their contribution to equity-market volatility in 2010 and the 8.6 percent intraday plunge in the Standard & Poor’s 500 Index on May 6, 2010.
Since those events, Morningstar analyst Michael Rawson and Federal Reserve Bank of Cleveland analyst Emre Ergungor have published research discounting the product’s impact on volatility and the 2010 stock-market rout, respectively.
SEC spokesman John Nester declined to comment on the agency’s inquiries or how it examines exchange-traded products on their way to market.
The SEC’s role in approving a new product depends on its type. The agency reviews registration statements of the shares or notes issued by all ETPs to make sure they meet disclosure requirements related to the securities and the issuer. Funds registering as investment companies are subject to additional reporting requirements and disclosures connected to investment objectives, risks and expenses.
What the approval process doesn’t include is a judgment on whether the product is any good, or who should use it.
“The SEC and federal securities laws don’t take a merit-based approach to regulation,” said Mercer Bullard, an associate professor of law at the University of Mississippi and founder of the advocacy group Fund Democracy Inc.
Michael Mundt, a former assistant director in the SEC’s division of investment management, said Finra may play a more important role in protecting investors from the hazards of complex ETPs as it enforces the brokerage industry’s standard of “suitability,” designed to make sure brokers match clients with appropriate products.
Finra in May fined four firms a combined $9.1 million for selling leveraged and inverse ETFs to clients who didn’t understand them and lost money. Finra is reviewing the Credit Suisse episode and “a host of issues relating to ETNs,” spokesman George Smaragdis said in an e-mailed statement.
“Credit Suisse is cooperating with regulatory authorities,” said Katherine Herring, a spokeswoman for the bank.
ETPs didn’t start out so complicated.
“The guiding mission of the first ETF was cheaper, better, faster exposure for investors to swathes of the stock market,” said Bloom, who, along with the late Nate Most, developed the first U.S. ETF at the American Stock Exchange in the late 1980s.
Before ETPs, investors could buy S&P futures or “program trades,” transactions with a brokerage that triggered purchases of a basket of shares. Comingled index trusts, a sort of mutual fund for institutional buyers, were another option. All were restricted to big players, or were cumbersome to access or exit, or both.
When John Bogle’s Vanguard 500 Index Fund appeared in 1976, it made buying all the benchmark’s stocks cheap and easy for small investors. Still, like all mutual funds, investors could only buy or sell at a price set once a day, after the market closed.
Most and Bloom solved the problem with the SPDR S&P 500 Trust, or the Spider. Registered as a unit investment trust under the 1940 Act, it held the securities it tracked, had about the same cost as the Vanguard index fund and had greater tax efficiency. And it traded all day.
It took more than three years to secure approval, and the Spider opened on January 22, 1993, under the trading ticker SPY. The fund, managed by Boston-based State Street Corp., remains the biggest ETF today, with $98.7 billion in assets.
“They were trying to develop something to drive trading on their exchange,” Gary Gastineau, author of “The Exchange-Traded Funds Manual” (Wiley & Sons, 2010), said in a telephone interview. “It also happens that the combination of features created the best collective investment product structure for securities in the world.”
Over the next several years, providers pushed gradually into narrower targets. Funds opened to track single industries and individual countries, followed by value and growth investing styles and specific market capitalizations.
While they became more specialized, the products remained linked to equity indexes that weighted companies according to their market size. And they tracked those benchmarks by holding all, or a substantial portion of, their component stocks. Most were registered under the 1940 Act, providing investors clear protections related to safeguarding assets and mandating the disclosure of certain information.
The 10 Biggest
Stock-oriented funds and UITs that fit those parameters today still account for about a third of all exchange-traded products in the U.S. and 60 percent of assets, data compiled by Bloomberg show. The biggest 10 hold $329 billion, or more than a quarter of all U.S. ETP assets.
In the rest of the industry, much has changed since the introduction of the first fixed-income fund in the U.S. in July 2002 and the first commodity-based product in November 2004. Another important wrinkle appeared during the same period as some providers began embracing non-traditional index weightings. Still, ETPs, including commodity trusts, held what they tracked and generally represented investment strategies that retail investors would recognize, such as long-term Treasuries or gold bars.
The introduction in 2006 of three new product types in the U.S., all based on derivatives, ushered in a profound change. While aimed at institutions, they also gave individual investors access to sophisticated and potentially risky bets.
Turning to Derivatives
The first was a commodity tracker from Deutsche Bank AG, in February 2006, that used futures contracts, making it possible to invest in materials difficult to receive and store, like oil and wheat.
ProShare Advisors opened eight leveraged and inverse ETFs in June that same year, using swap contracts to amplify or bet against the daily movement of an equity index.
The first exchange-traded note arrived that same month. Linked to a mixed commodities index, it held no product or derivative contracts; it was backed solely by the creditworthiness of its provider, London-based Barclays Plc.
“Generally, it’s good if you’re providing investors more choice and more access to institutional-class strategies,” said Adam Patti, founder and CEO of IndexIQ, based in Rye Brook, New York, whose products include an ETF that tracks an index of hedge funds. “Why should institutions and the ultra-high-net-worth have the only access to sophisticated investment strategies?”
Cost of Complexity
While giving investors new options, complexity has had its costs. Each of the three derivative-based product types has been involved in controversial episodes in which retail investors lost money not because the market moved against them, but because they failed to understand risks particular to a product.
Commodity investors who park money long enough in some futures-based funds lose money every month to traders taking advantage of the funds’ predictable need to roll out of near-term contracts before they reach their delivery date. The trading causes the contracts to fall in price just before the funds sell, and rise again after the wave of selling is over.
Leveraged and inverse ETFs present a peril for investors who don’t understand how gains and losses are compounded daily, causing returns over more than one day to differ from returns implied by the underlying index. In a settlement this month with Finra, Wells Fargo & Co., Citigroup Inc., Morgan Stanley and UBS AG agreed to pay a combined $9.1 million in restitution and fines to settle claims that they improperly sold the products in 2008 and 2009 to clients who lost money. In settling the claims, the firms neither admitted nor denied the charges.
For ETNs, there was the meltdown of a Credit Suisse note. The bank on Feb. 21 said it had stopped creating units of its VelocityShares Daily 2x VIX Short Term ETN. Experienced investors knew that the lack of new supply amid rising demand meant the note’s price could come unglued from its underlying index, and stayed away when a premium appeared in the price. Less knowledgeable investors continued to buy, and got burned when Credit Suisse announced on March 22 it would soon begin reissuing the notes, prompting a plunge of 50 percent in two days, even as the index dropped just 5.9 percent.
The industry’s steady push to introduce more complex products isn’t driven by a desire to ensnare unsuspecting investors, Michael Sapir, chairman and CEO of ProShare Advisors, said in a telephone interview. It’s driven by the demands of smart investors, he said.
“To a large extent ETFs have been bought, not sold,” he said. “The industry has delivered products that investors have been asking for.”
Sapir said providers and investors each have responsibilities in seeking to minimize mishaps: Companies have an obligation to educate, and investors must do their homework.
“I don’t care if it’s a single stock ETF or some crazy warrant that trades in Hong Kong,” said James Ross, head of State Street’s ETF business, the world’s second-biggest. “If you are hitting a button to buy a product and don’t understand it, you probably should stop.”
Part of the problem may be that investors think they understand what they are buying when the name starts with the phrase “exchange-traded,” said Deborah Fuhr, head of London-based research firm ETFGI LLP. That can include a vast array of products generating returns in different ways under different regulatory structures with different tax rules.
“By lumping things into that bucket, people assume they are all one and the same,” Fuhr said. “That’s where people can have a problem.”
In educating users, providers are limited by their lack of direct contact with retail investors. Mutual-fund companies must maintain a record-keeping relationship with each shareholder and can restrict access to complex products. With ETPs, retail investors buy and sell strictly through a securities broker who obtains the shares off an exchange.
That makes the role of intermediaries like brokers and financial advisers central to how ETPs are bought and sold.
Finra’s first warnings about leveraged and inverse ETFs in 2009 had an impact among brokers that its recent fines may reinforce. Several firms, including UBS and Morgan Stanley, have stopped recommending the products or otherwise restricted their sales. Online brokers that cater to self-directed investors, like Charles Schwab Corp. and TD Ameritrade Holding Corp., said they have ramped up educational materials and added disclaimers that confront clients seeking to purchase leveraged and inverse ETFs.
Finra spokesman Smaragdis said the events illustrate an example of the agency “getting out ahead of significant customer harm.”
David Nadig, director of research at San Francisco-based ETF research firm IndexUniverse LLC, has argued that regulators should go further, installing “gates” in front of some ETPs that mirror the rules governing access to underlying markets. That could require brokerages to approve investors one-by-one for products that make heavy use of derivatives.
ProShare’s Sapir said explicit restrictions would be unfair if they singled out ETPs when mutual funds and other investment professionals use derivatives extensively. Regulators, he said, should continue to demand “full and fair disclosure” from providers without taking away valuable investment tools that customers demand.
“Do you want to turn the clock back 30 years?” he said.