June 6, 2010

The US Securities and Exchange Commission’s decision to review fund derivative use and defer exemptive applications for some actively managed exchange traded funds has prompted concerns that funds may have to rethink investment strategies.

The commission has said it is evaluating the use of derivatives by mutual funds, ETFs and other investment companies to determine if additional protections are necessary, particularly when it comes to leveraged or inverse ETFs.

During the review, it is deferring consideration of applications for exemptive requests that would allow actively managed ETFs to make major investments in derivatives the SEC deems risky.

The deferral applies to pending and new requests, but does not impact existing ETFs and other fund applications.

The SEC also has said it will consider applications from actively managed, fully-transparent ETFs not investing in futures, swaps and options.

Mutual funds have increasingly become investors in ETFs — baskets of securities that seek to track a benchmark but trade intraday and can also be leveraged and sold short.

And those that offer leverage or are meant to perform inversely to the index or benchmark they track have become popular.

They are admired for their growth potential and have seen record sales.

But leveraged and inverse ETFs have become the focus of regulators who warned that the products, which reset daily, may not be suitable for retail investors who plan to hold them for longer than one trading session.

The news of the deferral has elicited criticism from the industry that such a move could hamper innovation for funds that rely on actively managed ETFs, or even create a monopoly among those who have already secured their exemptive orders, putting other funds at a significant disadvantage.

Michael Mabry, a partner with Stradley Ronon Stevens & Young, says the funds that have already been granted those orders maintain an advantage until the SEC concludes its study.

“In terms of other funds that might want to invest in these kind of ETFs, it means that the selection of ETF complexes that are offering these kind of ETFs is going to be limited, and extremely narrow, for the indefinite future,” he says.

“Those fund groups, lucky for them, will not be having any competitors entering the market any time in the near future...

“To the extent you think the reason for this derivatives study is because of the sort of volatile behaviour of leveraged and inverse ETFs over a year ago, the ironic thing is that those very same ETFs have now been granted their virtual monopoly.”

One of those major ETF managers, Direxion Funds, says a monopoly is created in theory, but not in practice.

Andy O’Rourke, senior vice-president of Direxion, says while he agrees the development seems like an advantage for players like Direxion, it is not likely to have any impact on its competitive edge, as a lot of product companies do not have an interest in seeking the exemption now anyway.

“I don’t believe there are too many other firms out there that were implementing plans to enter the space,” he says.

While Direxion already has an exemptive order, he says any further product innovation will be stifled, pointing to another initiative he says is “dead in the water”.

The SEC says it recognises the market advantage gained by funds that already have exemptive relief, but it was still necessary for the commission to take a step back and look at the financial instruments, which have become increasingly complex in ways that shareholders do not fully understand.

“That’s always true in the exemptive area, it’s why we ultimately like to move from the exemptive to a rule,” says Andrew Donohue, director of the SEC’s Division of Investment Management.

While Mr Donohue says the review will not take years, he did not offer any more specific timeline, saying only that the review is being done with a degree of urgency.

Gerald Buetow, chief investment officer of Innealta, a division of Al Frank Asset Management, says a lack of exemptive relief could cause problems.

“If they don’t get it, they’re just going to move over to the swaps market anyway and they can get the same exposure,” he says. “It’s going to drive business away from the futures exchanges here in the US and they’re just going to go outside of the US to get their exposure anyway.”

Kevin Mahn, chief investment officer of Hennion & Walsh and portfolio manager of SmartGrowth Mutual Funds, says he hopes any regulatory activity or new legislation does not make it more difficult for professional money managers to use products such as ETFs.

“We should allow portfolio managers and institutional investors all the tools available to help mitigate risk in these volatile markets and this is just another example of one of those products,” he says.