Is the UK regulator taking aim at the right targets amongst retail investment products?
The UK securities market regulator, the Financial Services Authority, suggested that leveraged exchange-traded funds might be “generally unsuitable for the mainstream, retail market” in a discussion paper released yesterday, entitled ‘Product Intervention’.
The FSA’s warning on this particular fund category is late – coming nearly two years after regulators in the US market first voiced similar concerns.
The warning is also less relevant than it would have been a couple of years ago, because all the signs suggest that leveraged ETFs are already losing their lustre.
According to data supplied by the National Stock Exchange for the US market, where leveraged ETFs have always had a bigger share of the business than in Europe, gross annual cashflow in leveraged equity ETFs fell from US$19 billion in both 2008 and 2009 to a mere US$5 billion in 2010, suggesting that many investors have already abandoned this type of fund.
The FSA is undoubtedly right to draw investors’ attention to the decay problem that goes hand-in-hand with leveraged ETFs. [For anyone unfamiliar with the return decay inherent in leveraged and inverse exchange-traded products, our 2009 webinar gives a thorough description of the subject].
But classifying leveraged ETFs in the discussion paper as unsuitable investments for retail investors (along with two other categories, traded life policy investments and ‘the more complicated structured products’) seems rather arbitrary.
If the FSA is worried about return decay, then it could have made similar comments about equity volatility trackers and commodity ETPs, to name just two products suffering from the same type of problem during periods of contango, damaging investors who hold the ETPs for a multi-day period.
And, looking beyond ETFs, ensuring consistency in its approach to the whole range of retail investment products will present the FSA with a devil of a job.
For example and no doubt pre-empting regulators’ concerns, the db x-trackers website simply won’t show you any of its inverse or leveraged funds if you register as a retail investor (db x-trackers operates Europe’s largest range of such ETFs). You’ll need to log in as an institutional investor just to look at them (I hear). If you do, db x-trackers informs you that its funds of this type are for short-term trading only.
But the web portal of a well-known state-owned bank, the Royal Bank of Scotland, allows retail investors to select from a whole range of structured products, many of which are stuffed full of complex and non-transparent financial options, have leverage added on top, contain uncollateralised counterparty risk to the issuer and have no active secondary market.
Personally I’d happily own a simple inverse (minus one times the index return) ETF (and I do), whereas I’d steer clear of any such structured product.
Or, if the FSA wishes to take aim at particular categories of financial products that can be deleterious to investors’ health, how about all those bond funds whose selection criteria are still based on unreliable ratings from the major credit rating agencies? Their judgement proved utterly wanting during the credit bubble and appears to be again now when it comes to sovereign risk.
All this of course goes to the fundamental problem at the heart of financial market regulation. How do you ensure investor safety while allowing freedom of choice? Does defining certain products as too risky imply by default that others are OK, causing investors to switch off their critical faculties and leading to larger problems down the line? By intervening, are you making the problem better or worse?