A regulatory storm is brewing on the horizon, and the first drops of doubt are beginning to fall on the ETF industry. Both brokers and issuers are running for cover before the skies open up. Lawsuits, like lightning, could strike at any time, singling out a firm from the herd and driving deep cracks into the industry floor.Starting with a small firm called Edward Jones, brokers have bowed out of the leveraged ETF arena. Despite increasingly revealing warning labels, the wrong kinds of investors continue to get dragged into ultra-long or triple-down funds. Like many medications, leveraged ETFs were designed to treat specific conditions. Daily leveraged funds like Direxion's Daily Financial Bull ( FAS) or ProShares UltraShort Financials ( SKF) are designed to be used with existing portfolios to provide hedging capabilities. Long real estate? Hedge your portfolio over a single trading day with the purchase of ProShares UltraShort Real Estate ETF ( SRS). These useful remedies, however, can sometimes fall into the wrong hands or be taken for the wrong reasons. The heady rush of being ultra-long or ultra-short has proven to be a temptation too great for some investors who rushed to their brokers to get their fix. Once difficult to access, these strategies have been made available by the structure of ETF products. The Hippocratic oath of doctors does not extend to the offices of Wall Street, and questions have been raised about the dispensing of these ETF products. Not wanting to be seen as irresponsible drug dealers, brokerage firms are washing their hands of leveraged ETFs before the financial DEA comes knocking. Firms like UBS ( UBS) and Ameriprise ( AMP) have bowed out of the leveraged ETF business.
"I've always believed in the power of the market to drive innovation and drive down cost. I also believe in the individual and his or her ability to make reasoned decisions. I don't think our clients, or our competitors' clients, are looking for regulators or politicians to protect them from risk by constraining their choices."Schwab's comments suggest that some brokers may not restrict their product offerings on the basis of intimidation. ETFs, like drugs, should not all be dispensed in the same manner. Traditional ETFs, like Tylenol, should be available to all investors. The warning on the box plus a childproof cap should be sufficient to prevent a widespread misuse of traditional funds. Nontraditional ETF strategies, like prescription drugs, should require additional documentation. I've called for restricting access to leveraged ETFs to only those investors cleared for margin or options trading. These aren't suitable for unsophisticated do-it- yourself investors. While the regulatory storm so far has been a lot of thunder and no lightning, the noise has succeeded in disrupting the ETF industry. Regulators should react or fall silent so that brokers, issuers and ETF investors can go on with their lives.