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Even amid market turmoil and economic uncertainty, exchange-traded funds have never been more popular. But Congress and the SEC see the industry differently, and they're looking to take bold steps to clamp down on ETFs before they create another financial crisis.
The evolution of ETFs
When they first came out, exchange-traded funds were simple and easy to understand. Closely resembling index mutual funds, ETFs tracked well-established indexes by owning all the underlying component stocks. As a result, when you looked at daily holdings of ETFs, you'd see all the stocks you'd expect from whichever index the ETF followed.
But along the line, ETFs have broken ground in new sectors of the financial markets, opening the door for investors to put their money into previously unavailable investments. But with that new opportunity also came complexity. Here are just a few examples of ETFs that blazed new trails for investors -- along with some of the problems and concerns that came with them:
- When United States Natural Gas (NYSE: UNG ) became available, it seemed like the perfect answer for investors who wanted direct exposure to rising natural gas prices via futures contracts rather than the indirect connection that gas drilling and exploration companies gave them. But because of the nature of the gas futures markets, the ETF produced big losses even as gas prices remained relatively flat.
- Leveraged ETFs like Direxion Daily Financial Bull 3x (NYSE: FAS ) and ProShares UltraShort Silver (NYSE: ZSL ) gave investors the opportunity to magnify their returns from making smart short-term calls on the direction of particular markets. But those who used such products over the long term found out that in many cases, both bullish and bearish leveraged ETFs tracking the same underlying investment produced substantial losses.
Moreover, with the sheer number of ETFs available, not all of them can have the same high volume that industry leaders have. As a result, in the aftermath of the Flash Crash in May 2010, ETFs made up the majority of securities that required canceled trades due to unrealistically huge price swings.
Enter the regulators
It's with all that as background that Congress held hearings earlier this week on ETFs. At the hearings, BlackRock's (NYSE: BLK ) head of its iShares division, Noel Archard, suggested that lawmakers should draw a line in the sand between "straightforward" ETFs and those that use complicated derivatives rather than stocks and other actual physical holdings. BlackRock CEO Larry Fink actually likened ETFs to mortgage-backed securities, suggesting that leveraged and other derivatives-laden ETFs could carry the same sort of unseen risks that led to the financial crisis.
In response, the SEC said that it had no plans to approve any new ETFs that make significant use of derivatives. Yet opposition to the plan came from interesting directions. Although one could expect ProShares, which has a number of leveraged ETFs, to speak out against the idea of a second-class category of ETFs, what was surprising was that Vanguard also called BlackRock's proposal into question, citing the potential for greater confusion.
Throwing out the baby with the bathwater?
The real question, though, is whether all ETFs that have any kind of derivative exposure are bad. For instance, both ETF SPDR Gold (NYSE: GLD ) and closed-end fund Central Fund of Canada (AMEX: CEF ) pride themselves on having physical bullion in a vault backing up their respective shares. But with that bullion incurring storage costs, the underlying value of the SPDR Gold ETF has slowly eroded in terms of how many ounces of gold each share represents. Central Fund has only avoided the same fate by being able to issue new shares at a premium to its net asset value.
In addition, some ETFs use derivatives in an effort to reduce risk. The PowerShares S&P 500 BuyWrite Portfolio (NYSE: PBP ) is one example; the ETF uses a covered call option strategy on the S&P 500 index to increase income and reduce volatility. The result is a trade-off of less potential profit for less downside risk. Having less of a roller-coaster ride is something you'd think lawmakers would embrace -- not prevent.
Learning the hard way
The lesson that ETF investors have to take from this is that you have to understand the products you invest in before you buy them. If an ETF is too complicated for you to figure out how it works, then it doesn't belong in your portfolio. No amount of regulation will do better than following that simple rule.
We've found some ETFs that won't take you to the cleaners. Read about them in the Fool's special free report, "3 ETFs Set to Soar During the Recovery."