FSA chief executive Hector Sants has warned against the risks of leveraged ETFs in a comment made before the treasury committee last Tuesday.
Asked where he thought the next banking failure was likely to come from, Sants spoke about the dangers of risk being pushed out of the banking system.
He went on to say: "If you can put leverage in an ETF, and then consumers themselves buy the product with the leverage, the risk is that the leverage moves out of the visibility of the regulator from the point of view of regulating the manufacturers of product, and into the consumers of product.
"I don't think it's happening to a significant degree at the moment, but logically that is a potential area of risk we need to be very careful about".
However, it is debatable whether the potential of leveraged ETFs as a source of risk is an inherent property of the product.
BlackRock global head of ETF research and implementation strategy Deborah Fuhr says the bigger concern in the case of leveraged and inverse ETFs is that many users have failed to understand the way the products work.
Fuhr argues it is this which prompted the Securities and Exchange Commission (SEC) in the US specifically to warn retail investors against their use.
In August of last year the SEC issued an alert urging investors to consider carefully the particular properties of these funds.
It noted: "It is possible that you could suffer significant losses even if the long-term performance of the index showed a gain."
The confusion around the use of leveraged ETFs arises because the funds are rebalanced at the end of every day. This means they are designed to achieve their performance objectives on a daily basis, but returns are likely to differ significantly if held over a longer period of time.
ETF Securities, which offers a range of leveraged and inverse ETFs, says: "They are not a ‘buy and forget' type of investment, but this is not a failing of the product."
The product provider argues that there is a need to assess the funds properly when measuring their performance. Leveraged products, ETFS stresses, are not designed to track a multiple of a price change index, but of the daily percentage change, and exist to serve clients who want to take advantage of short term opportunities.
The firm does concede though that "clearly, ETF providers should try and make them as easy to understand as possible".
Fuhr agrees that the danger with leveraged ETFs is misunderstanding. She says that most cases she has heard of are those of people who had failed to assess properly the product prospectuses.
Leveraged ETFs have also come under fire for relying on swaps or options in order to amplify the daily returns of the underlying index, and they are being scrutinised as part of the SEC's review of derivatives-based funds, announced last March.
ETFS is quick to point out that their products are collateralised and marked-to market daily, in order to minimise the exposure to swap counterparties. Investors in short or leveraged ETFs are also protected to the extent that they can only lose up to their initial investment.
The company says it believes that other leveraged products, such as over-the-counter derivatives and spread betting, would not compare well.
Whatever their advantages though, the effect of all this confusion has been that many private banks are not allowing retail investors to take new positions in leveraged ETFs.
Fuhr says that the challenge for Sants, and all regulators, is trying to identify where the next risk is - "a very difficult thing to do".
Ultimately, Sants was rather circumspect, offering only that the next failure will be "something to do with risks occurring away from the core banking system." In the meantime, both Fuhr and the SEC recommend that investors do their homework.
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