Exotic ETF outcry: Much ado about nothing?

When it comes to leveraged and inverse ETFs, seemingly every regulator and influential brokerage firm has recently voiced the opinion that these exotic vehicles — which can double or triple the returns (or short the losses) of a market index — are inappropriate for individual investors. Most advisers, however, figured that out a long time ago. There are few advisers who do not use exchange-traded funds these days — roughly 91% of 440 advisers polled by InvestmentNews yesterday rely on ETFs to make up a piece of their clients' portfolios. Yet even though advisers are clearly comfortable with ETFs, only a minority of advisers polled this week are putting leveraged, inverse or leveraged-inverse ETFs to work for their clients. Only 26% of advisers polled by InvestmentNews this week said they use these exotic ETFs in their clients' portfolios. Their clients, meanwhile, seem to have even less interest in these ETFs: Just 7% of advisers polled by InvestmentNews noted that they are asked by a client to employ leveraged or inverse ETFs. So if just a small fraction of investors are clamoring for these ETFs, and just one-quarter of advisers actually use them, why the fuss? Clearly regulators, such as the Securities and Exchange Commission and the Financial Industry Regulatory Authority Inc., have made addressing these funds a priority in recent weeks. The SEC and Finra issued a joint alert on leveraged ETFs last month in which they warned investors about the performance of these vehicles. Their point is fair: Many investors don't understand how leveraged ETFs are supposed to work. Most of these exotic ETFs “reset” on a daily basis, as Finra puts it. So if an ETF aims to double the returns of the S&P 500 index, it will actually only double the returns of the index on a single day. This means that an investor who holds onto this leveraged ETF over a three-month period in which the S&P 500 is up 40% may only see a 60% gain in their ETF — not 80%. There was, and is, a need to explain these complex vehicles. But in addition to issuing regulatory warnings, many large broker-dealers — including Morgan Stanley Smith Barney, UBS Financial Services Inc., Ameriprise Financial Inc., LPL Financial and Raymond James Financial Inc. — have all reportedly placed restrictions on the sales of leveraged ETFs. According to the InvestmentNews survey, roughly 40% of brokers and advisers now have some firm-wide policies in place preventing them from including leveraged ETFs in their clients' portfolios. Given the infrequent usage and minimal demand for these strategies, is this an overreaction to a non-existent problem? Possibly. But it's also possible that it's an overreaction to a problem that doesn't exist yet. Just a year after a major financial meltdown, the industry may still be sensitive to what can happen when investors and institutions don't understand the products they actually buy (remember credit default swaps and collateralized debt obligations, circa 2008?). Maybe it's a pre-emptive strike against an issue that could affect scores of investors. Maybe it's simply a way for regulators and financial institutions to eventually say “we told you so” and cover their, um, tracks. But advisers apparently got that message a long time ago: don't buy what clients don't understand and don't want. Simple rules still apply around even the most complicated of investment vehicles, apparently.