UBS’s decision to suspend purchases of its leveraged and inverse ETFs on Monday came, we understand, largely on the advice of industry regulator Finra who in June stated :
“…inverse and leveraged ETFs that are reset daily typically are unsuitable for retail investors who plan to hold themfor longer than one trading session, particularly in volatile markets.”
Adding:
“This Notice reminds firms of their sales practice obligations in connection with leveraged and inverse ETFs. In particular, recommendations to customersmust be suitable and based on a full understanding of the terms and features of the product recommended; salesmaterials related to leveraged and inverse ETFsmust be fair and accurate; and firmsmust have adequate supervisory procedures in place to ensure that these obligations aremet.”
In suspending the funds UBS becomes the first high-profile name to really take the guidance to heart. The precedent it has set for the industry, meanwhile, is already becoming evident.
On Wednesday, Dow Jones reported Morgan Stanley Smith Barney had also placed under review the sales of its leveraged and inverse exchange-traded funds “that regulators said might not be suitable for individual investors”.
This, obviously, has big implications for an industry which until recently appeared confident of further growth, largely via the ETF-isation of ever more exotic underlying assets. A good demonstration of the industry’s heightened diversification came in June with Pimco’s launch of an ETF offer set to give “retail” investors the chance to invest in a slice of the bond-giant’s mutual fund profits. As the Wall Street Journal commented at the time:
Pimco’s move could re-order the ETF business. Bond offerings, Pimco’s specialty, are one of the fastest-growing areas of the business. While several other bond ETF families have opened, then closed their doors, none had anywhere near the cachet of Pimco, which manages about $760 billion.
Of course the more the industry steps away from its traditional indexing heritage, the more it stands to confuse investors with offers that some say should really be labelled exchange-traded ‘structured products’, due to their propensity to behave unexpectedly.
It does seem that the more complexity that enters the industry the more it propels itself towards an institutional rather than retail client base. This is demonstrated by the following charts from BGI (H/T Herbie Skeete).
Worldwide ETF asset growth as at end of December 2008:
Growth in institutional users of global ETFs in the same period:
The key point the current blowup demonstrates is that an important distinction should now be made within the industry which currently tends to use the ETF name as an umbrella term for all its offshoots – plain vanilla index-focused ETFs, exchange-traded-commodities (ETCs), exchanged-traded-notes (ETNs) and exchange-traded-products (ETPs).
The latter, of course, being more suited to institutional rather than retail investors.
Meanwhile, if you want to see how things can really go wrong in an ETF structure, note the following SEC filing from the United States Natural Gas Fund (UNG) released late on Wednesday, in which the fund — already forced into the bilateral market by position limits — admits it could now be forced into buying completely unrelated assets with a poorer correlation to natural gas futures.
As Olivier Jakob, an energy market analyst at Petromatrix sums up the story:
We have in the past called the ETFs on single-commodity Futures a cancer for the Futures market. From the current CFTC hearings on position limits it does seem that the main commodity investment banks are now in the process of trying to manage rather than fight the process of setting position limits in the energy markets. In order to preserve some of their core business we would think that investment banks will have to sacrifice the concept of open-ended commodity ETFs.
Related links:
The ETF blow-up begins - FT Alphaville
UNG goes OTC - FT Alphaville
Statistical arbitrage and the retail ETF con-fusion – FT Alphaville