Background

An exchange-traded fund (“ETF”) allows an investor to buy and sell shares in a single security that represents a fractional ownership interest in a pool of securities and other assets. An ETF originates with a sponsor who chooses an ETF’s target index or investment objective and policies, determines which securities will be included in the portfolio of securities, and decides how many ETF shares will be offered to investors. Unlike an exchangetraded note (“ETN”), which is an unsecured promissory note of a bank or other sponsor where the sponsor does not establish a separate entity to issue the notes and to acquire a portfolio of securities to backstop its obligations, an ETF issuer is a separate entity from the sponsor and is not subject to claims of the creditors of the sponsor. The table below is a summary comparison of ETFs to ETNs.

ETFs are listed on a national securities exchange and can be bought and sold like common stock throughout the trading day. Typically, ETFs are either registered unit investment trusts or open-end investment companies that have obtained an exemptive order or other relief from the SEC.1 Since March 2008, the SEC has considered a proposal that would allow ETFs to begin trading without the need to obtain individual exemptive orders.2 The proposed rule would give ETFs even greater flexibility and “is designed to eliminate unnecessary regulatory burdens, and to facilitate greater competition and innovation among ETFs.”3 ETFs can already do things that most mutual funds cannot, such as trading throughout the day on an exchange instead of at that day’s closing price and using leveraged and inverse trading techniques in creative ways.

One permutation of the ETF structure is an ETF that seeks to produce a return that is a multiple of the return of its underlying index. Commonly known as a “leveraged” ETF, the ETF uses futures or other derivatives to multiply the daily return of the underlying index. An inverse (or “short”) ETF is designed to correspond to the inverse of the daily performance of the underlying index. An ETF that is both leveraged and inverse seeks to deliver daily returns that are a multiple of the inverse of the daily performance of the underlying index.

Rebalancing with Leverage

Because leveraged ETFs are designed to generate daily returns that are a multiple of the daily return of the underlying index or the opposite of the daily return of the underlying index (in the case of inverse ETFs), these ETFs are reset each day.4 As a result of the daily reset feature and the leveraging effect, the returns on a leveraged ETF over time can differ significantly from the performance (or inverse of the performance) of the underlying index during that same period. For example, assume on day 1 an index starts with a value of 100 and a leveraged ETF that seeks to double the return of the index (a “2x” leveraged ETF) starts at $100. If the index drops by 10 points on day 1, it has a 10% loss and a resulting value of 90. Assuming that the leveraged ETF achieved its stated objective, the leveraged ETF would, therefore, drop 20% on that day and have an ending value of $80. On day 2, if the index rises 10%, the index value increases to 99. For the leveraged ETF, its value for day 2 would rise by 20%, which means that the leveraged ETF would have a value of $96. On both days, the leveraged ETF produced daily returns that were two times the daily index returns. However, if one compares the results over the 2-day period: the index lost 1% (from 100 to 99), while the 2x leveraged ETF lost 4% (from $100 to $96). As a result, over the 2- day period, the leveraged ETF’s negative returns were 4 times as much as the 2-day return of the index instead of 2 times the return.5

Regulatory Responses

Leveraged and inverse ETFs have attracted regulatory attention. In June 2009, the Financial Industry Regulatory Authority (“FINRA”) issued a Regulatory Notice reminding brokers and securities firms of their “sales practice obligations in connection with leveraged and inverse ETFs.”6 Specifically, FINRA emphasized that recommendations to investors must be “suitable and based on a full understanding of the terms and features of the product recommended” and that securities firms must have “adequate supervisory procedures” in place to ensure that those obligations are met.7 Citing the daily rebalancing feature of leveraged and inverse ETFs, FINRA stated that these ETFs are “typically … unsuitable for retail investors who plan to hold them for longer than one trading session, particularly in volatile markets.”8

Subsequent to FINRA’s June 2009 Regulatory Notice, the SEC and FINRA issued a joint alert on August 18, 2009 based on their belief that “individual investors may be confused about the performance objectives of leveraged and inverse exchange-traded funds.”9 In particular, the agencies stated that some investors may have the incorrect “expectation that … ETFs may meet their stated daily performance objectives over the long term as well.”10

On August 31, 2009, FINRA issued an additional Regulatory Notice in which, effective December 1, 2009, it increased the maintenance margin requirements for leveraged ETFs and associated uncovered options by a factor commensurate with their leverage.11 The then current requirement for a leveraged ETF was 25% of the ETF’s market value. The new rule increased that requirement to 50%. In a triple leveraged ETF, the requirement is now 75%. In an inverse ETF, the margin requirement was 30% of the ETF’s value. Under the new rule, the requirement was doubled to 60%. The requirements will not exceed 100% of the ETF’s market value.

State regulators also have recently focused on leveraged and inverse ETFs. In October 2009, the Kentucky Department of Financial Institutions and the Montana Commissioner of Securities and Insurance issued news releases that alleged that leveraged ETFs were a top “investor trap” that posed a threat to investors in 2009.12

Looking Ahead

The number of leveraged and inverse ETFs and the volume of their trading activity have grown substantially since the first leveraged and inverse ETFs were launched in 2006. As of November 1, 2009, there were 283 leveraged and inverse ETFs listed on Bloomberg, holding over $100 billion in assets. The total trading volume on November 1, 2009 exceeded 959 million shares. Faced with increased regulatory scrutiny, issuers and sponsors of leveraged and inverse ETFs have begun updating their offering documents to highlight the skewed risks attributable to those products. Financial institutions also have issued cautionary statements regarding those products.13 Whether the use of leveraged and inverse ETFs will continue to grow in light of these efforts and despite the recent regulatory focus – including the not insubstantial new margin requirements – remains to be seen.