FSA slams leveraged ETFs

The FSA has warned leveraged ETFs could be classed as 'generally unsuitable' for the mainstream retail market, along with complicated structured products and trade life policy investments.

The regulator's latest discussion paper goes on to consider the possibility of publishing a list of such products as part of an adoption of less interventionist means to steer the market.

The distribution of this material, the FSA stresses, would not amount to banning the named products, but "would make it clear that the starting point is that these products are unsuitable for most retail customers."

Leveraged ETFs use derivative instruments such as futures contracts and swaps to give long or short returns of a particular index. However, confusion arises because of a strategy of daily rebalancing, which means a fund's performance can deviate significantly across the longer-term from that which is implicated by its name.

It is these types of cumulative returns that Fundsmith founder Terry Smith branded "apparently perverse" in a letter to shareholders earlier this month. In America, the Securities and Exchange Commission has issued a specific alert to individual investors about leveraged and inverse ETFs, "because we believe individual investors may be confused about the performance objectives".

Brunning Newman Houghton IFA David Brunning says he has had problems with leveraged products in the past and does not recommend these types of ETFs to clients. He agrees with the FSA's cautious attitude and says he thinks it is possible to achieve the same results for investors using traditional products.

However Anthony Badaloo, an IFA at Church Hill Finance, says: "The problem comes with inexperienced investors, where these products become something like a form of extreme speculation."

The FSA's mooted warning addresses this same issue, stating: "It would still be possible for a distributor to recommend the product, but this list would be a signal that the product is likely only to be suitable for certain segments of the retail market (for example, sophisticated customers capable of fully understanding the way in which the product works and the likelihood of it failing)."

But there already stands a wealth of pre-existing product literature behind the FSA's impromptu advice.

Db x-trackers, for example, produces a brochure for potential investors. The front cover reads: "The db x-trackers on daily leveraged long and short indices are designed for financially sophisticated institutional investors who want to use them for short-term investment strategies. They are not suitable as a buy and hold investment."

The ETF Securities website carries a risk warning below all its leveraged funds, specifying that these types of vehicles "are only suitable for sophisticated investors who understand leverage, compounded daily returns and are willing to magnify potential losses".

Both companies clearly agree with the FSA on the type of investor leveraged ETFs suit; the SEC, too, was targeting "buy-and-hold investors" when it published its own warning.

"The FSA is right to be sounding a note of caution," says Badaloo. But he points out that these interventions raise issues of parity. "Increasingly, technology is allowing the small investor to be on an equal footing with institutions and fund managers. In a sense, why shouldn't ordinary investors be allowed to use whichever instrument is necessary to gain a particular exposure?"

Badaloo says a rating system might be more appropriate. "I think perhaps we need a special category of risk designed for leverage to help both consumers and advisers - this is a new breed of risk and one we haven't really seen before."

According to BlackRock's most recent figures, leveraged and inverse ETFs had assets of $38.3bn as at the end of 2010 - less than 3% of global ETF assets. Badaloo says: "To be honest, most IFAs wouldn't venture into recommending leveraged ETFs anyway. There is an element of self management there."

He adds: "Perhaps what we'll see is a learning curve develop, where there'll be negative stories for a couple of years before people start to become more knowledgeable about leveraged ETFs. The concern is that if the FSA steps in with regulation, it could strangle this process so the market doesn't develop as it should."