The Securities and Exchange Commission is conducting a review of certain types of exchange traded funds. The SEC’s primary focus is on leveraged and inverse leveraged exchange traded funds and actively managed exchange traded funds, especially derivatives-based exchange traded funds. See John Spence’s Wall Street Journal article, “Leveraged ETF’s Are Under SEC Scrutiny.”
The SEC said its staff will consider possible additional protections for investors under the Investment Company Act of 1940, and will put a freeze on new and pending exemptive requests made by exchange traded funds that would make significant investments in derivatives ? a step that could make it problematic for the fund to operate.
“It’s appropriate to engage in a more thorough review of the use of derivatives by ETFs and mutual funds given the questions surrounding the risks associated with the derivative instruments underlying many funds,” said SEC Chairman Mary Schapiro.
“Although the use of derivatives by funds is not a new phenomenon, we want to be sure our regulatory protections keep up with the increasing complexity of these instruments and how they are used by fund managers,” said Andrew Donohue, Director of the SEC’s Division of Investment Management. “This is the right time to take a step back and rethink those protections.”
More specifically, the SEC Staff’s review will address the following concerns regarding exchange traded funds:
- Whether exchange traded funds’ use of derivatives is consistent with the leverage, concentration and diversification provisions of the Investment Company Act
- Whether funds that rely substantially upon derivatives, particularly leveraged derivatives, have adequate risk management
- Whether board of directors are providing appropriate oversight of the use of derivatives by exchange traded funds
- Whether new rules and procedures regarding pricing and liquidity determinations regarding its derivatives holdings are needed
- Whether prospectuses adequately disclose the particular risks created by derivatives
- Whether use of derivatives should be subject to special reporting requirements.
The SEC Staff will also consider other possible changes in Commission rules or guidance with regard to exchange traded funds.
Like traditional mutual funds, exchange traded funds may either seek to track an underlying benchmark or securities index or be actively managed. Unlike traditional mutual funds, shares of an exchange traded fund can be traded throughout the day on a securities exchange. In addition, “leveraged” exchange traded funds are index-based exchange traded funds that seek to deliver multiples or inverse multiples of the daily performance of the selected index using swaps and other derivatives.
The Financial Industry Regulatory Authority has said that leveraged exchange traded funds are unsuitable for “buy-and-hold” investors and most individual investors.
Curiously, according to the WSJ article, leveraged exchange traded notes are not included in the SEC review. The reason for this is not clear. Exchange traded notes are debt instruments issued by a financial institution. The return of the note is linked to the return of an underlying asset such as the S&P 500 Stock Index. But they can also be linked to derivatives, which is the focus of the SEC’s review of exchange traded funds. Thus, exchange traded notes, particularly leveraged exchange traded notes, carry all of the risks that exchange traded funds do. In addition, these notes often promise “principal protection;” however, that promise can be misleading because it is dependent upon the issuer’s ability to pay, and is thus subject to the additional credit risk of the issuer. Exchange traded notes are not funds, however, and are not registered under the Investment Company Act of 1940. That may be a reason why they are not included in the SEC’s review, if that is, in fact, the case.
Page Perry is an Atlanta-based law firm with over 125 years collective experience representing investors in securities-related litigation and arbitration. While past results are not indicative of future success, Page Perry’s attorneys have recovered over $1,000,000 for clients on more than 30 occasions. Page Perry’s attorneys are actively involved in representing institutional and corporate investors that lost money in exchange traded funds. For further information, please contact us.