The exchange-traded funds market may be growing fast, but regulatory uncertainty remains over products such as commodity, inverse, leveraged and active ETFs. And there's pressure to get quick resolution on structural issues, says State Street Global Advisors (SSgA), the world's second biggest ETF provider.
Global ETF assets under management grew by 31% to $933 billion in the nine months to September 30, with the Asia-Pacific region accounting for $62 billion, or around 7% of the total, said SSgA in a report* published yesterday. But Asia-Pacific ETF assets are growing faster than those of any other region, having risen by 50% in the same period.
However, certain types of ETFs are attracting the attention of regulators around the world. Commodity products, for example, have raised concerns -- particularly among US regulators, which govern the bulk of the global commodity market -- over the effect of speculative activity on the price of the underlying commodities. A few commodity ETFs invest in the physical commodity, but most use futures to replicate their exposure, and these appear to be a particular cause for concern.
Both the US Securities and Exchange Commission (SEC) and the US Commodities Futures Trading Commission (CFTC) seem likely to consider proposals in the near future, says SSgA. Reports indicate that the CFTC may propose putting caps on ETF asset size or market share, so that no single player can control the market.
Regulatory action can cause ETFs to liquidate or stop new share issuance, notes the SSgA report. The CFTC recently withdrew exemptions from limits on corn and wheat futures issued to Deutsche Bank. Soon after that, the German bank said it would liquidate its PowerShares DB Crude Oil Double Long ETN. Other funds, such as the United States Natural Gas Fund and iShares S&P GSCI Commodity Index Trust, have stopped issuing new shares.
As a result, the development of the futures-based commodity ETF market remains uncertain, says SSgA, which manages $204 billion of ETF assets.
Another area of uncertainty is inverse and leveraged ETFs. These products have been the subject of numerous column inches documenting regulators' -- and market participants' -- worries that they are not suitable for retail customers.
Leveraged products seek to produce a multiple of the performance of the underlying benchmark, while inverse products are designed to generate a mirror-image performance, once, twice or three times the opposite performance of a benchmark. For example, if the S&P 500 drops 1% in one day, a series of inverse ETFs would aim to generate +1%, +2% and +3%, respectively.
The US Securities and Exchange Commission approved both types of ETFs in 2008, but has indicated it may complete an additional review by the end of this year, notes SSgA. The reason is that, while ETFs are held mainly by institutions, retail investors constitute the majority of owners for the top-three inverse and leveraged products.
Moreover, the US Financial Industry Regulatory Authority says inverse and leveraged ETFs are not typically suitable for longer-term retail investors, as they reset daily and thus their returns may diverge widely from the benchmarks over time. (And some in the market have suggested that ETFs in general are unattractive as long-term investments for most institutions.)
As a result of the lack of regulatory certainty, some US providers have not entered this market, while others -- such as UBS and Morgan Stanley Smith Barney -- are halting or restricting sales efforts until the regulatory picture is clearer.
This is less of an issue in Europe, where relatively few retail investors use ETFs there and regulators have yet to comment on these products.
As for another relatively nascent form of these products -- actively managed ETFs -- a couple have been launched in the US, although Europe has had a few active ETFs for years now, notes SSgA. Tony Rochte, a senior managing director for the firm, told AsianInvestor late last year that "the jury is still out" on active ETFs.
The SSgA report says: "Regulations and reporting processes must evolve to address structural problems. For example, investors need to know the components of a fund to actively hedge it, but fund managers don't want to reveal their holding for fear of front-running or copycatting." Short performance track records also present a challenge for active ETFs.
Mutual funds of ETFs are in the earliest development stages in the US, says the report. Their primary use in the US may be in 401(k) retirement saving plans, but regulations governing 401(k)s were designed to accommodate mutual funds, not ETFs, notes SSgA, meaning "logistical and legal asymmetries must be resolved".
Some areas where 401(k) requirements differ dramatically from ETF offerings include pricing, market access and reporting procedures. Yet while the 401(k) market may be off limits for now, says the report, mutual funds of ETFs may "open the flood gates to retail investors".
With regard to hedge fund ETFs, they are -- unlike their underlying market -- well regulated under the SEC, says SSgA, and at least 15 such products have filed for approval and should be launched in the US soon.
*Exchange-traded funds: Maximizing the opportunities for institutional investors.