Exchange-traded funds, or ETFs, have become increasingly popular among investors because they're more liquid and tax efficient than mutual funds and give them exposure to stocks, bonds and commodities they otherwise might not be able to access.

However, some of these ETFs have also become increasingly complicated and difficult to understand as firms roll out new funds on an almost daily basis to satisfy the specialized tastes of investors who now hold ETFs worth more than $1 trillion.

A decline in transparency for some ETFs has led the Serious Fraud Office, which prosecutes white collar crime in the U.K., to begin an investigation into whether there is a need for more regulation and perhaps a need for new tools to prosecute fraud in the ETF industry.

No similar inquiry is reported to be under way here in the U.S. where, unlike in Europe, there is a prohibition against banks that issue ETFs also being the counterparty with the index.

But Standard & Poor's ETF analyst Todd Rosenbluth says that doesn’t mean that American investors in ETFs shouldn’t pay closer attention to what they are actually trading.

“There are a lot of people investing in ETFs who have absolutely no idea what they are buying,” Rosenbluth said.  “People aren’t doing their homework, and they need to.”  

This lack of awareness, combined with the hype, is exactly why U.K. officials are taking a closer look not only at how the funds are constructed but how closely they actually mimic the performance of the funds they're supposed to track.

ETFs are bundles of stocks that are designed to track a particular index. Most money goes into ETFs that track very broad, well understood and transparent indexes like the S&P 500 or the Russell 2000. But the marketers of ETFs are always coming up with new products which often track so-called synthetic indexes which are ready made for the ETF to track.

“Investors need to monitor how well their ETF is tracking the index,” says Rosenbluth.  This is also particularly true, he said, with inverse and leveraged ETFs, which are becoming increasingly popular as hedges among smaller investors. An inverse ETF is supposed to move in the opposite direction of its index, while a leveraged ETF is supposed to magnify the movement of the underlying index.

In Britain, Hector Sants, chief executive of the Financial Services Authority, Britain’s version of the SEC, questions “whether synthetic ETFs really are appropriate for all types of the retail marketplace.” 

To date, no specific companies or ETF products have been a target of prosecution, but the FSA and the Serious Fraud Office clearly think that the potential for abuse is there, particularly in the case of thinly traded ETFs that track synthetic indexes.

In April, the Financial Stability Board, a group of global regulators and central bank officials, declared that some parts of the ETF market “warrant closer surveillance by regulatory authorities.”  The SEC, as well as the Federal Reserve Board and the US Department of the Treasury are all members of the FSB.

The Securities and Exchange Commission, which would be responsible for initiating any kind of investigation of ETFs and their providers, won’t say if it’s investigating any ETF’s for frauds or other problems, but the agency did announce a moratorium in March 2010 on approval of any ETFs that relied on “significant use of derivatives.” That moratorium remains in place.

For now, experts like S&P’s Rosenbluth say, the best thing for investors in ETFs is caveat emptor. “Know what you are investing in,” he said.




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