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The leveraged and inverse ETF sector in the US has been thrown into turmoil in recent weeks. The intervention of regulator FINRA, a ban on sales by several brokers and a recent class-action lawsuit against a leading ETF provider have posed serious threats to what had been the fastest-growing section of the ETF industry. In Europe, on the other hand, things have remained relatively quiet. Will this state of affairs continue? Or could the boom in leveraged and inverse tracker products be forced under the spotlight on this side of the Atlantic too?
While this sector of the ETF market is smaller in Europe than in the US, it has nevertheless seen substantial growth over the last year or two. According to Deutsche Bank’s recent ETF Liquidity Trends report, funds in this category had just over €4 billion in assets under management at last count, a 3.3% share of the total €123 billion ETF market. In the US market, leveraged and inverse ETFs have close to a 6% market share, with US$25 billion invested.
When measured in terms of trading volumes, however, these funds constitute a more important part of the market than their assets under management suggest. Five of the top 10 European equity ETFs by daily trading volume in the week ending 6 August fell into the leveraged and inverse category, as did four of the top 10 in the US market over the same period.
So what could be the knock-on effects for European investors of the recent controversy over leveraged and inverse funds in the US? And, given the well-publicised tracking problems of some leveraged ETFs, might there be better ways for investors to gain short or geared market exposure than by using these types of funds?
In the community of ETF providers that offer leveraged and inverse funds, both Hector McNeil, Partner at ETF Securities, and Manooj Mistry, UK head of db x-trackers, say that they are watching developments in the US closely. Mistry believes it is vital that investors are given the right disclosure and risk warnings about these products and are aware that inverse or leveraged returns are guaranteed for daily periods only; db x-trackers will shortly be adding the word “daily” to its short (inverse) ETFs to make this absolutely clear.
Given that most European inverse and leveraged ETFs track UCITS-compliant indices (indices that have been approved by regulators as the basis for exchange-traded funds on the grounds of sufficient diversification), a representative of one ETF provider noted, it is unclear how regulators might object to such funds.
At iShares, which has been conspicuous on both sides of the Atlantic in its absence from the leveraged and inverse funds sector, Nizam Hamid, head of sales strategy, questions whether investors have really been given sufficient information about how these funds work. “These products are fundamentally flawed in terms of how they are positioned and explained to investors,” he said. “Whilst leveraged and inverse products have become popular in Europe from a trading perspective, they have had limited traction in terms of assets under management. European providers need to improve the level of education regarding these products significantly.”
There are other ways for ETF investors to achieve leveraged or short (inverse) market exposure than by using these funds. Take, for example, a more traditional margin account that allows an investor to achieve both objectives without creating the longer-term tracking problems that result from ETFs having to reset their leverage to a fixed percentage on a daily basis. Here, two distinct viewpoints seem to have emerged. Some firms stress the importance of working on making it easier to develop short-selling activity in traditional “long” ETFs by developing the securities lending market, while other providers continue to focus on offering leveraged and short exposure as a “packaged product” – in other words, within the ETFs themselves.