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In the week during which the Obama administration will unveil details surrounding its plan to revamp the regulation of the U.S. financial sector, calls for increased oversight of the ETF industry are picking up steam as well. Scott Burns, director of ETF Analysis at Morningstar, recently laid out a case for increased regulatory requirements for ETFs that use derivatives to achieve their objectives.

But I'm not quite convinced that more regulation is the answer.

In The Beginning...

The first ETFs were equivalent to "plain vanilla" financial instruments, tracking well-known equity and fixed income indexes by duplicating their underlying holdings. Even today, the simplest ETFs remain among the most popular - the indexes tracked by the largest ETFs by market capitalization should be familiar to almost all investors.

But as the ETF structure became more familiar and investors became more educated on the advantages of ETFs relative to traditional mutual funds, the floodgates opened, and several ETF sponsors raced to be the first to cover tiny corners of the investment universe.

The result: increasingly complex ETFs whose objectives are beyond the comprehension of many "amateur" investors.

Leveraged ETFs

Once proven to be popular among buy-and-hold investors, fund sponsors turned their attention to the opposite end of the spectrum: day traders. With a propensity for moving in and out of positions with astonishing frequency, this target market presented itself as a profitable field of untapped potential. The solution? Leveraged ETFs.

Similar to traditional ETFs, leveraged ETFs track an underlying index of equities, bonds, or commodities. But leveraged ETFs use derivatives and other complex financial instruments to provide amplified returns on the target benchmark. For example, ProShares Ultra QQQ (NYSEARCA:QLD) seeks daily investment results that corresponds to 200% of the daily performance of the NASDAQ 100 Index.

Beyond QLD, ProShares maintains a complete line of 2x leveraged and inverse leveraged ETFs, which Direxion offers 3x leveraged funds.

While leveraged ETFs generally do an excellent job of tracking daily returns, problems arise when investors hold these funds for extended periods of time (i.e., more than a day). Due to the compounding of returns, returns of leveraged ETFs can vary significantly in magnitude (and even direction) of the amplified return on the underlying index over a given period.

The following charts present the year-to-date return of several well-known "plain vanilla" ETFs, as well as the returns on several 2x and 3x ETFs that track the same index.

2x ETFs

3x ETFs

The 3x leveraged Russell 1000 ETFs are perhaps the best example of the risks associated with compounding daily returns on leveraged ETFs. Although IWM is up 4.3% year-to-date, its 3x bull fund is actually down more than 15%, and its 3x bear ETF is down a whopping 52.7%. Investors who bought TNA at the beginning of 2009 would have been severely disappointed if they held the ETF over the last five plus months.

So, as Burns puts it, "the possibility for the average investor to suffer an adverse investing experience has increased tremendously." And on this point he is absolutely correct. The possibility exists.

To combat the problem of unsuspecting investors getting in over their heads, Burns and the team at Morningstar propose holding ETFs that utilize derivatives to the same approval standards applied directly to derivative investments. Specifically, he would require any investor with a trading or brokerage account to get approval to purchase options and derivatives.

Burns notes that the approval process for derivatives is pretty straightforward - applicants must read (or acknowledge that they have read) a 216-page overview of how options work and the associated risks.

Let's Take a Step Back

While I agree that there exists potential for confusion over these investment vehicles causing investors to unknowingly take inappropriate risks, I'm not convinced that forcing them to read a textbook (or, more likely, lie by checking a box that says they read a textbook) on the risks of making such investments is the solution to the possible problem.

Behind Burns' logic is the implication is that the issuers of leveraged ETFs are trying to pull a fast one over on Joe Investor, peddling these funds as one-size-fits-all investment vehicles for buy-and-holders and day traders alike.

Such a scenario couldn't be further from reality.

ProShares' web site is littered with warnings of the risks and intended uses of leveraged ETFs, complete with easy-to-understand examples of the impact of compounding returns. Direxion's web site maintains a thorough education center which even directs readers to several articles that have some less than complimentary things to say about leveraged ETFs.

Moreover, a standard Google search for "leveraged ETFs" brings up dozens of cautionary tales.

Here's my point: if potential investors are oblivious to the existing, readily accessible warnings, what good is a 200+ page tutorial going to be? At best, it would be similar to the materials presented on ProShares' web site. At worst, it would be too overwhelming to seriously consider (these are, after all, "average" investors we're talking about), and would be completely ignored.

As far as I'm aware, the only evidence of this problem is anecdotal. Implementing regulations that risk being duplicative and are guaranteed to be expensive and time-consuming seems like overkill.

Not Total Hooey

While I think Burns' plan for investor approval would amount to little more than a waste of time and money, he makes several very valid points regarding the education of financial advisors on the complexities of leveraged ETFs.

Coming from a veteran of the advisor conference circuit, his tales of professional money managers being completely unaware of issues resulting from holding leveraged ETFs for the long-term are extremely unnerving (and even more disconcerting since Matt Hougan of IndexUniverse has recounted similar stories).

I can understand how the intricacies of leveraged ETFs can escape casual investors. What is unfathomable, however, is investment professionals allocating client funds to inappropriately risky assets without being aware they are doing so.

While Burns' evidence for this phenomenon is once again purely anecdotal, this seems like a rather serious problem.

And on this one, his solution - calling on organizations such as NAPFA, NAIFA, and FINRA to educate its members - makes a whole lot of sense to me.

Disclosure: No positions.

Source: More ETF Regulation Is Not the Answer