Thu, July 16, 2009
MA Secretary of State Investigating Leveraged Exchange-Traded Funds
As more attention is focused on to the risks of leveraged exchange-traded funds (ETFs), regulators are starting to investigate how they’re being sold to retail investors.
Massachusetts Secretary of State William Galvin,whose office is responsible for regulating securities in the Commonwealth, has announced that he’s asked three vendors of exchange-traded funds to provide him with copies of their training and sales materials for leveraged ETFs. Reuters quoted Galvin’s statement that he intends to “conduct a review of the sales materials which are provided to Massachusetts investors and further assess the compliance procedures and supervision of Massachusetts broker-dealers offering these securities to retail investors.”
Rydex Investments, Direxion Funds and ProShares all received letters from Galvin asking for information. Although the three are not the largest ETF providers around (that distinction belongs to Boston’s own State Street Global Advisors), they’re major vendors in the $33 billion leveraged ETF marketplace.
My guess is that Galvin will not find any smoking guns, because ETF vendors usually do a good job of disclosing risks in their sales materials. It’s unlikely that they’d be encouraging brokers in writing not to disclose the fact that these products are primarily appropriate for day trading. The problem is that although these risks are disclosed – if only in the fine print – what really matters is what the retail product salesmen tell their customers. Without knowing that it will be hard to know whether sellers are properly drawing investors’ attention to the risks of leveraged ETFs.
The SEC, which is responsible for approving new ETFs, may be signalling an attitude shift on the leveraged products. Andrew Donohue, who directs the SEC’s Division of Investment Management, recently gave a speech in which he expressed concern “about the increasing use of leverage by funds. While sophisticated investors might have the ability to properly evaluate the impact of employing leverage in funds, I question whether many retail investors can.”
Additional protections for retail investors, even if only through more explicit rules about risk disclosure, do seem appropriate for leveraged ETF products.
While looking for information on Galvin’s scrutiny of leveraged ETFs, I happened upon a white paper on the role of state regulators in protecting the investing public. Galvin, with other state securities regulators, is becoming concerned that in the course of changing financial industry regulation, Congress may take away some of the authority of state regulators. The paper, “States’ Demonstrated Record of Effectiveness In Their Investor Protection Efforts Underscores the Need to Avoid Further Preemption of State Enforcement Authority” describes the ways in which state regulators have played an important role in protecting investors in the past and argues that “further preemption of state regulatory authority would be detrimental to consumers of financial services and for the economy as a whole.”
There will undoubtedly be some polite pushing and shoving between Congress and state attorneys general over this issue, and the financial industry will argue that if greater federal regulatory restrictions are put in place, state regulatory power should indeed be reduced. Of course, if big financial companies would just quit doing nasty things to investors, there’d be no need for so much regulation, and the financial industry could save a lot of money in fines, to boot.
Until that becomes the norm, keeping the states in the game seems like a good safeguard.
7/20/2009 - link added to original post
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