How Should Regulators Handle Exchange Traded Funds?

Financial regulators in Europe and the U.S. are struggling to figure out how to respond to the fast growth of the $1.6 trillion exchange-traded fund ("ETF") industry. ETFs have surged in popularity. While many brokers and investors fail to distinguish ETFs from mutual funds, ETFs actually are very different from mutual funds. EFTs can be traded through the day like stocks. They also allow investors to go long or short and to take on leverage in an effort to boost their gains. While ETFs originally were devised for institutional investors, about $800 billion in ETFs are held by individuals. Many of these investors (along with the brokers who sold the ETFs) do not understand the investments. Such misunderstanding often leads to ETF investment losses.

ETFs have become controversial. The funds, some of which use derivatives and leverage, can subject investors to enormous risk of loss. The leverage funds, for example, are designed to be traded on a daily basis. Yet, many retail brokers sell such ETFs to individual investors as long-term, buy-and-hold investment. But investing in the ETFs in that manner is unsuitable and often can lead to catastrophic investment losses.

UBS suffered $2.3 billion in losses as a result of ETF trades. ETFs are one of a myriad of complex financial products that have caused billions of dollars of losses over the last several years. Those products include: collateralized mortgage obligations (CMOs), collateralized debt obligations (CDOs), credit default swaps (CDS), and structured notes, including Lehman Brothers structured notes sold by UBS. Investors also have lost millions of dollars in complex investments such as ASTA and MAT funds sold by Citibank and its affiliate Smith Barney. Many investors did not understand ETFs and these other products and many brokers and brokerage firms failed to explain the investment adequately when they sold the investments.

Because of the financial upheaval that has taken place in the financial markets over the past few years, significantly caused by ever-more-risky complex financial instruments, securities regulators are expected to increase the regulation of ETFs. Such regulation is expected to include increased and better disclosure to investors about the nature and risks of ETFs.

Due to the massive increase in sales of ETFs to individual investors, it is imperative that securities regulators create more stringent rules designed to protect individual investors from the perils of risky ETFs. If further is important that brokerage firm properly educate their brokers about ETFs so that the brokers do not make improper recommendations and sales of these complex investments.

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