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Watching, waiting

Authorities eyeing ETFs, but big changes not likely

030512 rominger
Watching: Eileen Rominger says the SEC has been conducting a ‘general review.’

The growing world of exchange-traded funds is coming under increasing scrutiny of U.S. authorities, and some changes are expected in Europe in the next few months.

But, sweeping changes are not on the horizon.

In October, a top official of the Securities and Exchange Commission disclosed the agency was conducting a broad review of ETFs.

“Commission staff is currently engaged in a general review of exchange-traded products in connection with, among others, the adequacy of investor disclosure, liquidity levels and transparency of underlying instruments in which ETPs invest, fair valuations, efficiency in the arbitrage process and the relationship between market volatility and ETPs,” said Eileen Rominger, director of the SEC's Division of Investment Management.

Her comments were included in prepared testimony to a U.S. Senate Banking subcommittee hearing.

It wasn't the first time the SEC said it was looking at ETFs.

In March 2010, the agency announced it had suspended approval of ETFs that used derivatives — such as leveraged ETFs or actively managed ETFs that use futures, options or swaps — while it examined the use of derivatives in exchange-traded products.

The review, which also extends to the use of derivatives in other investment products, is continuing, and applications for new leveraged and/or active ETFs that use derivatives have not been approved.

“Based on recent testimony and comments from the SEC staff, it appears that the staff is revisiting a wide range of fundamental ETF issues,” said Michael Mundt, a partner at law firm Stradley, Ronon, Stevens & Young LLP in Washington. “I would expect this review to delay consideration of new types of ETFs for the immediate future.”

Mr. Mundt is a former assistant director in the Division of Investment Management at the SEC, where he supervised the review of applications to introduce ETFs.

Several sources familiar with how the agency operates who asked not to be identified agreed, saying the latest ETF review is so broad it's unlikely to result in any new regulations in the next year.

SEC spokeswoman Florence Herman said the agency would have no comment on the SEC reviews of derivatives and ETFs.

European proposal

In Europe, meanwhile, the European Securities and Markets Authority announced on Jan. 30 proposed regulations that would require ETFs to disclose whether they lend securities, as well as to detail information on the collateral they hold.

The agency said it expected to issue final regulations on those topics by mid-2012.

But those changes aren't the major issues the ESMA expressed concern about in a discussion paper in July. In the paper, the agency talked about creating a classification system for ETFs and even banning the sale of more complex ETFs — such as synthetic ETFs, which make up around 40% of the European market — to retail investors.

The authority in a news release on Jan. 30 said it would continue to study the issues but offered no time frame for completion.

In an e-mail, Reemt Seibel, the authority's communications officer, said it continues to review what regulation is needed to deal with the increasing number of complex ETFs in the European market.

“ESMA reiterates the need to tackle these issues and will continue to contribute actively to the regulatory response to these problems, which will come in a new version of the EU Markets in Financial Products Directive,” he wrote.

Synthetic ETFs have caused concern because they replicate index returns through the use of derivatives, exposing investors to potential counterparty and collateral risk. A more typical ETF tracks a basket of securities in an index.

Officials at Black Rock Inc., the world's largest ETF provider, are calling for a global classification system for ETFs along risk lines, generating controversy among the firm's competitors.

Noel Archard, managing director and head of U.S iShares products, said at the congressional hearing in October that leveraged or inverse ETFs should not be allowed to call themselves exchange-traded funds because they are too opaque.

And Laurence D. Fink, BlackRock (BLK)'s CEO, compared ETFs to the mortgage-backed securities market during BlackRock's third-quarter earnings call, the same day as the congressional hearing.

“We saw in the mortgage market in the "80s and then in the "90s and then in this decade, a simple product morphed into something that was very complex, and risks were contained in these products that maybe investors did not know,” he said in the call. “That was the failure of the mortgage market.”

Mr. Fink in the same call said BlackRock needs to be outspoken so ETF investors understand their risks. “We believe these products can have a huge future, and we need to be a lot more assertive in making sure that risk and complexity is understood by all investors.”

Black Rock has no leveraged or inverse ETFs. Only four of the 269 BlackRock ETFs listed in the U.S. would be affected by the firm's proposed classification system. Its two ETF competitors in the U.S. that offer leveraged and inverse ETFs, ProShares and Direxion, would see major changes.

“As an investor, you should carefully understand the risks before your purchase,” said Jennifer Grancio, iShares managing director and a member of iShares global executive team. “It's not about good and bad for us — it's about classification and understanding the difference between these types of products.”

BlackRock's plan

Under the BlackRock (BLK) proposal, leveraged and inverse ETFs would be labeled exchange-traded instruments, Ms. Grancio said.

Andy O'Rourke, senior vice president and marketing director at Direxion Funds, Boston, said in an interview that changing the funds' classifications is not necessary and would not help investors.

“The (leveraged and inverse) funds are designed for short-term traders,” he said. Mr. O'Rourke said investors in the Direxion ETFs understand their investment risk.

ProShares officials would not comment for this story, but in written testimony at the Senate banking subcommittee hearing, CEO Michael Sapir said the ETF classification system called for by BlackRock is “arbitrary, anti-competitive and unworkable. The recommendation might serve BlackRock's competitive interests, but would not serve investors' interests and (would) likely result in confusion.”

Members of Congress, including Sen. Jack Reed, D-R.I., who chaired the hearing on ETF regulatory issues, have not introduced any legislation to codify BlackRock's recommendations and there is no plan to do so, sources said.

Chip Unruh, a spokesman for the senator, did not return repeated phone calls.

BlackRock has also tried to sell the its proposal classification system through the Investment Company Institute's ETF subcommittee, but is having little luck so far.

Ms. Grancio said BlackRock continues to discuss the issue through the ICI subcommittee so there can be an industry recommendation on what new egulations are needed.

James Ross, a senior managing director at State Street Global Investors and global head of its ETF business in Boston, is chairman of the ICI subcommittee. He said there has been no consensus on the issue, and he doesn't see a recommendation being brought forward to create the classification system.

Gus Sauter, chief investment officer of the Vanguard Group, Inc., Valley Forge, Pa., also is opposed to the proposal. “We're just concerned about painting everything with this big broad brush,” he said.

In reality, Mr. Sauter said, there are ETFs that could fall into the low-risk category — such as those targeting emerging market segments — that are not broadly diversified among their holdings and would be risky investments.