Chuck Jaffe: Regulators issue a meaningless "warning" on ETFs
Sometimes, investors need to be protected from the people and agencies who are trying to protect them.
That kind of situation occurred again recently when the North American Securities Administrators Association (NASAA) issued an advisory about exchange-traded funds (ETFs), worried that investors "may not understand how these complex investment products work or the potential risks they may face."
Cut through the rhetoric and the NASAA advisory boils down to a reminder to ask two questions before buying an ETF: Do I understand this investment? Is this investment right for me?
Indeed, in issuing the warning, David Massey, the North Carolina deputy securities administrator and current NASAA president, noted: "As with any investment, investors should know what they are investing in."
Well, if securities regulators are warning the public against "complex investment products" and urging them to do their homework, they might as well issue investor advisories against stocks, bonds, traditional mutual funds, most bank notes and almost any other type of investment that an ordinary investor can buy.
"It was less like an investor advisory and more like they were doing Mad Libs, and every time they needed to insert a form of investment they said 'ETFs,' " said Paul Justice, director of ETF research at investment researcher Morningstar. "This is an advisory that seems to do nothing except maybe steer some people away from what, for them, might be an intelligent investment choice."
Aside from tarring an entire ETF business with a broad brush, it actually appears that the state securities regulators missed a key point of their job, the part where they protect the public from investments that are innately and inherently dangerous for the investing public.
Instead, it looks like the regulators may misunderstand exchange-traded funds every bit as much as the public.
What's more, if this investor advisory truly was necessary, then it was needed a few years back, as the ETF business took steps to move from the lawless new frontier to respectability. Not only should regulators have seen the warning signs, they could have stopped the problems. Instead, they waited way too long to speak up, and now have confused the same investors for whom ETFs have become a viable investment.
Exchange-traded funds and traditional mutual funds are similar at their core — a pool where investors place money to get diversification and professional management and strategy at a reasonable price. But mutual funds trade once per day and are restricted in pursuing many sophisticated (and leveraged) investment strategies, while ETFs trade like stocks, minute by minute. ETFs traditionally have been based around indexes, while traditional funds offer indexing strategies but also come in a variety of actively managed flavors.
Because ETFs are more easily traded and are priced in real time — instead of at the end of the trading day like a traditional fund — they can be used in timing and trading strategies. As a result, many of the more esoteric ETFs are built to reflect the buyer's sentiment for the day, so that if there's a reason to think a sector or an entire market will move in a specific direction, an investor can buy a fund that captures two or even three times that daily move.
Mind you, before ETFs were popular, there were traditional mutual funds that were built to be trading vehicles and that would attempt to move double the market's daily gain or loss. They were just as inappropriate for a long-term investor as the leveraged ETFs are today.
The NASAA advisory does make a few good points about ETFs, such as the clear danger of "liquidation risk." As the business expands, seemingly every investment idea that has a hint of merit is being thrown out in ETF form, and many of those new funds are shuttered when they don't attract much money or can't post a decent early track record.
Likewise, the leveraged and inverse ETFs that truly seem to be what NASAA was warning about really do come with trading consequences, from fees and transaction costs to tax consequences that investors truly should understand.
Mostly, however, the public should have seen the warning and responded this way: "Thanks for the warning guys; now don't you have any real work to do?"
Instead of issuing an investor advisory stating the obvious — that investors need to "know (their) investment objectives and risk tolerance" — the state securities regulators might have wanted to push for some action on the part of the people creating these ETFs that may not be suitable for everyone.
There are other investment vehicles that regulators have decided investors need to be particularly careful about before buying, such as options. Investors buying options must fill out a disclosure statement saying they understand the risks and that they believe the investment is suitable for them.
If regulators truly worry about leveraged ETFs, they could require a similar disclosure statement. It's not going to stop some novice from blowing up their portfolio, but it might get them to think twice before pushing the plunger.
I don't think that kind of disclosure is necessary in a world that should be ruled by the caution of "caveat emptor," where the wary buyer is savvy enough to read a prospectus and to check out the risks before they take on any investment. There's no denying, however, that requiring disclosure would protect investors far more than some vague, ill-conceived "warning" that investors should know what they are getting into with ETFs.
Investors should know what they are getting into regardless of the asset type they are buying. No matter how many next-generation, newfangled investment ideas come to market, "understand the risks" and "know what you are getting and how it works" will never go out of style.
If you need to be reminded of those investment basics, you have a lot more to worry about than whether ETFs are right for you.
Chuck Jaffe is senior columnist for MarketWatch. He can be reached at firstname.lastname@example.org or
Box 70, Cohasset, MA 02025-0070.
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