SEC Ruling: Active ETFs Now Allowed To Use Derivatives

by on December 14, 2012 | ETFs Mentioned:

Though exchange-traded funds have without question revolutionized and democratized Wall Street by allowing average investors to gain cheap and easy access to nearly every corner of the investable universe, there has understandably been some backlash concerning the nuances and uses of these products. And considering the industry’s relatively short history, it is perhaps not surprising that government agencies, namely the U.S. Securities and Exchange Commission, have launched several investigations and reviews into various aspects of exchange-traded products [see 101 ETF Lessons Every Financial Advisor Should Learn].

Back in March of 2010, the SEC began a review of the use of derivatives by ETFs, specifically actively-managed and leveraged funds. Norm Champ, Director of the SEC’s Division of Investment Management, stated that “The use and complexity of derivatives have grown significantly over the past two decades and have given rise to many interpretive and policy issues under the 1940 Act.”

But after over two years of analysis and review, the SEC finally made its decision last week: fund companies are now able to seek regulatory permission to include derivatives in actively-managed ETFs. There are, however, explicit stipulations that fund managers must adhere to [see also Actively-Managed ETFdb Portfolio]:

  1. The ETF’s board must periodically review and approve the ETF’s use of derivatives and how the ETF’s investment advisor assesses and manages risk with respect to the ETF’s use of derivatives.
  2. The ETF’s disclosure of its use of derivatives in its offering documents and periodic reports is consistent with relevant Commission and staff guidance.

The SEC stressed that it will continuously review this issue, but in regards to decisions concerning the use of derivatives by leveraged exchange-traded funds, they are still hesitant to grant permission. Champ expressed his concern over these powerful products, stating that “Because of concerns regarding leveraged ETFs, however, we continue not to support exemptive relief for such ETFs.”

What Does This Mean For ETF Investors?

Derivative use has been a touchy subject for many investors, as these powerful instruments have led to some of the worst financial disasters of all time. On the other hand, they have also provided lucrative opportunities for those with the knowledge and in-depth understanding of how exactly these products work. But will using derivatives in actively-managed ETFs do more good or harm for investors? Unfortunately, the most reasonable answer is that only time will tell. Below we outline the top five actively-managed funds that investors may want to keep a close eye on [filter by active/passive and other fields with the free ETF Screener]:

Ticker ETF Expense Ratio AUM
BOND Total Return Exchange-Traded Fund 0.55% $3.9 billion
MINT Enhanced Short Maturity Strategy Fund 0.35% $2.1 billion
ELD Emerging Markets Local Debt Fund 0.55% $1.5 billion
ALD Asia Local Debt Fund 0.55% $462 million
CEW Dreyfus Emerging Currency Fund 0.55% $276 million
 *As of 12/13/2012

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Disclosure: No positions at time of writing.