Leveraged ETF Shut Down Won't Be Last

NEW YORK ( TheStreet.com) -- Deutsche Bank ( DB) announced that it will shutter PowerShares DB Crude Oil Double Long Exchange Traded Note ( DXO) as the war against energy "speculators" claims its first exchange-traded product.

The ETF industry has been under fire all summer and the battle is being waged on multiple fronts by multiple regulatory groups. DXO, unfortunately, was caught in dual crossfire: It is a futures-based commodity fund and it is leveraged.

Futures-based commodity funds like DXO and U.S. Natural Gas ( UNG) have been under fire this summer as the Commodities Futures Trading Commission holds hearings. It is expected that upcoming regulation will limit the number of futures contracts that each fund can own in an effort to cap the effect that any single fund can have on the market.

In an announcement yesterday, Deutsche Bank alerted investors that it would be redeeming the $425 million in outstanding DXO notes. The press release from Deutsche Bank notes that "limitations imposed by the exchange on which Deutsche Bank manages the exposure of the Notes have resulted in a 'regulatory event' as defined in the terms of the Notes, which has caused Deutsche Bank to redeem the Notes."

According to the Financial Times, the CFTC has denied any action against DXO. This statement seems to be irrelevant, since DXO, along with other futures-based commodity funds, have been backed into a corner.

As financial regulation becomes the new pet cause of politicians in Washington, one of the first targets is "energy speculators" who manipulate the spot prices of popular commodities like gas and oil. About a year after the oil bubble burst and crushed shares of funds like U.S. Oil ( USO), the CFTC is examining the effect that passive indexing instruments like ETFs have on commodities prices.

In an effort to stem the effect that the seemingly inevitable regulation will have on futures-based commodity funds, multiple ETF issuers have halted share creation. DXO and UNG both halted share creation earlier this summer. Other funds like the iShares S&P GSCI Commodity Indexed Trust ( GSG), iPath Natural Gas ( GAZ) have also halted creation as the CFTC debate continues.

Since ETFs and ETNs are designed to track an underlying index, issuers create new shares as more investors pour into the fund. The creation process helps to keep these funds in line with their underlying values. By halting creation and essentially turning the ETFs and ETNs into closed-end funds, issuers can doom funds to trade at extreme premiums and discounts to their underlying value.

Why then has DXO shut its doors as other stunted funds like UNG continue to trade? Because of its unique structure, DXO has been threatened from more than one proposed regulatory action. Since DXO tracks futures contracts, it first faces limitations from the CFTC. DXO is a leveraged fund, making it part of a second group of exchange-traded products that have come under fire.

In a "special alert" released yesterday, FINRA announced that it would be increasing margin requirements for leveraged ETFs as of Dec. 1. These changes will require margin for leveraged funds to be "commensurate" with the degree to which they are leveraged.

The changes to margin requirements come in the wake of several attacks against leveraged funds. In a June release, FINRA "reminded firms of their sales practice obligations with respect to leveraged and inverse ETFs, including the risks caused by the fact that most of these funds are designed to achieve their stated performance on a daily basis."

FINRA's warning set off a domino effect as firms like Edward Jones, Ameriprise ( AMP) and UBS ( UBS) ceased selling leveraged funds to investors. A lawsuit is also currently pending against ProShares UltraShort Real Estate ( SRS) on the basis of sales practices.

DXO's methodology seems to have been in the wrong place at the wrong time. In yesterday's announcement, however, Deutsche Bank was careful to note that no other ETNs would be affected by the announcement. Other Deutsche Bank ETFs, like the Crude Oil Double Short ETN ( DTO), also employ leveraged futures-based commodity strategies.

It is hard not to have mixed feelings about the fall of DXO and the pursuit of similar products by regulators. ETFs and ETNs have provided the average investor with unprecedented access to commodity and leveraged-based strategies and increased regulation could shrink the market for these products.

While these strategies can be dangerous in the hands of the wrong investor, they are useful tools for hedging when employed properly. ETFs issuers have perhaps been overzealous in the release of nontraditional ETF funds, but regulators have been equally overzealous in their pursuit of them.

As the ETF battle intensifies, DXO may be the first victim but it will likely not be the last. Leveraged, futures-based commodity and currency exchange-traded products could all face severe restrictions as financial regulation heats up.

-- written by Don Dion in Williamstown, Mass.
At the time of publication, Dion had no positions in the stocks 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.