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ETF Providers Can Avoid SEC Hammer

Stocks in this article: IYF FAS EGPT

Over the past few weeks, the ETF industry has come under fire as the Securities and Exchange Commission continues its investigation into the use of derivatives in the trading and structure of exchange traded products.

Although ETFs were originally designed to passively track a basket of stocks or bonds, as the industry has evolved fund providers have launched a vast number of products that use derivatives, allowing investors to take bullish and bearish bets on broad markets or individual market slices. These derivatives can also be employed by actively managed products in order to help them better reflect their underlying indexes.

One side effect of this shift toward derivatives has been an increase in expense ratios. While a traditional ETF like the iShares Dow Jones US Financial Index Fund (IYF) charges investors 0.48% in fees, a leveraged fund like the Direxion Daily Financial Bull 3X Shares (FAS) charges 0.94% -- nearly double the fees of the unleveraged product. Active funds tend to charge even steeper fees.

Given the higher fees associated with derivative based funds, it is no wonder that companies like JPMorgan, Legg Mason and Goldman Sachs have proposed launching their own actively managed products. Unfortunately for them, the SEC's decision has put these plans on ice.

As I mentioned in an article last week, while investors have been ensured that products currently trading will be unaffected by this sting, the regulatory body has put a hold on the launch of any new derivative-based ETF products until the current review is wrapped. This means that for now, fund issuers looking to make money from expensive active and leveraged funds will need to find another ETF avenue that allows for higher expenses.

One possible area of the market these companies may consider exploring is that of the exotic international instruments. Today, with the global economy on the rebound, investors seeking returns are turning their attention abroad. In response, a number of ETF providers have followed suit, launching a number of new products designed to slice international markets into ever thinner segments.

While international products have traditionally tracked popular developed and emerging markets through large-cap indexes, companies are increasingly looking to frontier nations, small-cap firms, and international sector slices for new investing opportunities. Like leveraged and active products, these new international funds typically carry higher expense ratios than traditional exchange traded options.

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