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ETF Regulators Drop the Hammer

NEW YORK (TheStreet) -- As the Obama Administration transitions from the successful completion of health care overhaul to the daunting task of financial regulation, ETFs are once again coming under fire. Not one, but two regulatory agencies are turning up the heat on some of the most popular and actively traded segments of the ETF industry.

Both the Securities and Exchange Commission and the Commodities Futures Trading Commission have announced plans to look into the role that derivatives play in the structure and trading of ETF products.

While both of these agencies have targeted ETFs in the past, the latest effort promises to have the momentum of broader financial reform behind it. Regulatory changes could dramatically impact the availability and trading of certain commodity ETFs and leveraged ETFs. This is a situation that investors should continue to monitor closely.

The SEC's effort, announced last Thursday, is targeting leveraged ETFs that financial regulators have been warning investors against since last spring.

Leveraged ETFs utilize derivatives to allow investors to make bullish and bearish bets. Aimed at sophisticated investors, leveraged ETFs have proved hazardous for buy-and-hold investors.

Regulatory warnings during 2009 touched off a wave of lawsuits and caused some investment managers to abandon the funds altogether.

The SEC announced last week that it would be conducting a review of derivative-based ETF products, and that it would be putting a freeze on the release of additional derivative-based ETF products while the review was completed. Readers interested in reviewing the press release can do so here

The SEC review, however, will also include derivative-based commodity ETFs. Since some commodity funds such as the United States Natural Gas ETF (UNG) and the United States Oil ETF (USO) have had to periodically register with the SEC for new shares, the SEC has been closely involved with the growth of many commodities ETFs.

This is not the first time that the SEC has announced that it would be taking a special interest in the growth of derivative-based commodity funds. Last summer, as regulators promised to monitor the markets of commodities with "finite supply," the SEC exacted a telling toll on shares of UNG.

As interest in natural gas spiked last summer, a rush of investors into UNG prompted fund managers to request the creation of additional shares. When the SEC initially denied this request, shares of UNG traded to a premium.

So this isn't the first time that the SEC intends to shape the ETF industry. ETF investors have experienced the kind of disruption that regulatory uncertainty can cause.

In the meantime, the CFTC is mulling its own plans to employ stricter position limits on the various futures-backed ETFs and ETNs. The regulation will affect funds that are designed to track commodities of finite supply. This is being done in an effort to prevent an ETF from becoming so big that it distorts the marketplace.

This will not only affect energy ETFs, such as USO, but also other derivative backed funds designed to track metals such as gold and nickel. Though there are no immediate plans in place to investigate "soft" commodities such as cocoa and sugar, it may only be a matter of time before they are included in the discussion as well.

The CFTC has been attempting to impose stricter position limits for derivative-based commodities ETFs for some time now. Impending position restrictions have caused ETFs to shut down (the case of DXO), restructure (the cases of DBA and DBA) and change their underlying indexing (the case of UNG, which switched to swaps when the CFTC made moves to put limits on the US exchange-traded market for natural gas futures).

Position limits will place a cap on the number of futures contracts any single fund can carry, ultimately limiting their size. This will pose an issue if a futures-backed fund grows so large that it reaches this limit. At that point it would be unable to generate any additional shares, leading to the emergence of a premium.

Noticeably absent from the renewed focus on leveraged- and commodity- backed ETFs is the Financial Industry Regulatory Authority. Last summer Finra issued warnings over the dangers of using leveraged ETFs.

On Monday, Finra told Reuters that, though it was not a fan of restricting product innovation, it had its eye on the ETF product pipeline to see if new regulation is required.

Though the SEC and CFTC may take two different approaches to ETF regulation, both agencies are targeting the broad range of funds that use derivatives to achieve their objectives. Some ETFs, positioned in the crosshairs of both agencies, could be particularly vulnerable.

The PowerShares DB Gold Double Long ETN (DGP) not only tracks a "finite" commodity, it also does so using leverage. Holding this fund amidst this ongoing regulatory storm will likely prove risky.

As the SEC and CFTC continue to crack down on the ETF industry, investors need to be more cautious than ever when managing their investment portfolio. Unless you are a sophisticated investor using leverage or commodity futures-backed ETNs and ETFs to achieve a specific goal, these types of funds should be avoided until this regulatory storm blows over.

In the meantime, investors should continue to turn to the funds that stand by the original three tenets of the ETF industry: transparency, liquidity, and low cost.

-- Written by Don Dion in Williamstown, Mass.

At the time of publication, Dion was not long any equities mentioned.

Don Dion is president and founder of Dion Money Management, a fee-based investment advisory firm to affluent individuals, families and nonprofit organizations, where he is responsible for setting investment policy, creating custom portfolios and overseeing the performance of client accounts. Founded in 1996 and based in Williamstown, Mass., Dion Money Management manages assets for clients in 49 states and 11 countries. Dion is a licensed attorney in Massachusetts and Maine and has more than 25 years' experience working in the financial markets, having founded and run two publicly traded companies before establishing Dion Money Management.

Dion also is publisher of the Fidelity Independent Adviser family of newsletters, which provides to a broad range of investors his commentary on the financial markets, with a specific emphasis on mutual funds and exchange-traded funds. With more than 100,000 subscribers in the U.S. and 29 other countries, Fidelity Independent Adviser publishes six monthly newsletters and three weekly newsletters. Its flagship publication, Fidelity Independent Adviser, has been published monthly for 11 years and reaches 40,000 subscribers.

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