ETF Providers Can Avoid SEC Hammer

ETF providers should consider alternative international instruments to avoid SEC scrutiny.
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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) - Get Report

charges investors 0.48% in fees, a leveraged fund like the

Direxion Daily Financial Bull 3X Shares

(FAS) - Get Report

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.

This theme has picked up considerably in 2010 with the launch of a number of unique international products including the

Market Vectors Egypt ETF (EGPT) - Get Report

, the

IndexIQ Canada Small Cap Index Fund

(CNDA)

, the

IndexIQ Australia Small Cap Index Fund

(KROO)

and the

Global X China Materials ETF

(CHIM) - Get Report

, one of many China sector funds offered by firm. On Wednesday, Van Eck will launch its newest international product

: the Market Vectors Latin America Small Cap Index ETF

(LATM)

.

For now, no ETF newcomer, whose plans were put on ice by the SEC, has shown signs of joining this trend. However, the benefit of offering new alternative international products is two-fold: the nature of these types of funds allows ETF providers to justifiably boost expense ratios while at the same time allowing investors access to previously untapped segments of the global market.

Of course, with these and any new launches, investors need to be conscious of volume.

With the regulatory assault on derivative-backed ETFs still dragging on, providers planning to launch active and leveraged products may want to consider weighing other options in their quest to make an impact on this lucrative industry. By introducing alternative international instruments, they can not only charge high expense ratios while avoiding the SEC's hammer, but also provide investors with exciting new investing opportunities.

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.