Short ETFs under microscope as SEC pounces Tue Apr 14, 2009 7:08pm EDT By Jonathan Spicer - Analysis NEW YORK (Reuters) - The explosion of exchange-traded funds that profit from falling stocks has caught the eye of U.S. regulators looking to curb short selling, but despite their demonization by some, it's hard to blame ETFs for declines in equities. The Securities and Exchange Commission has hinted that so-called leveraged inverse ETFs such as UltraShorts could be included in new rules aimed at curbing short selling. Erik Sirri, the SEC's director of trading and markets, said last week that "we could carve them out, or could loop them in" to restrictions on short sellers. The sharp market drop has put immense political pressure on the SEC to do something to limit the shorting of individual stocks. Some critics are also leveling fire at ETFs, which trade like stocks but instead track an underlying index or basket of assets. Leveraged inverse ETFs are considered "synthetic" because they use a formula of options and other derivatives to yield two or even three times the profit when the underlying assets fall. They have allowed some trading firms to thrive throughout the downward spiral in stocks. This has raised the ire of some, especially when the assets are hard-hit shares of banks getting emergency government funding. But it is unclear how much influence ETFs have on the underlying assets, to which they are only indirectly connected. Further, the SEC's initial recommendations target the selling of borrowed equities, whereas ETFs involve the buying of funds. "Although big trading of ETFs can move indices, they basically trade derivatives, so they're really not involved with the cash markets," said Jamie Selway, managing director of institutional broker White Cap Trading. "I can see how they would create late-day volatility," said Selway, a board member at BATS Exchange, the No. 3 U.S. equities market. "But if the problem is levered bear funds that drive markets down, addressing the short selling isn't going to matter because here the manipulation happens through buying." In less than three years, the U.S. leveraged inverse ETF market has swelled from nearly nothing to $12 billion, according to Barclays data. Despite the wrenching market contraction set off last year, the U.S. leveraged inverse market has grown 26 percent in the last 12 months. The majority of these products "reset" daily, meaning investors must cash out regularly to get the proper return. This makes leveraged bear funds ideal for the growing ranks of high-frequency traders that place hundreds of orders per day, driving demand for the leveraged products and pushing them into the spotlight. This month, outspoken CNBC commentator Jim Cramer said aggressive short sellers have used ProShares' UltraShort Financials product to "pound bank stocks down," suggesting they should be banned. Cramer's on-air guest, NYSE Euronext (NYX.N) Chief Executive Duncan Niederauer, responded that the products could be "re-evaluated, potentially repositioned, and maybe even reinvented" -- but he stopped short of agreeing that a ban was warranted. The New York Stock Exchange, which like other exchanges has come to rely on ETFs to maintain growing trading volumes, later told Reuters it would ask the SEC to exempt ETFs from any new rules to curb short selling. ANOTHER EXEMPTION? Short selling is a trading strategy in which investors sell borrowed shares in the hope of buying them back later at a lower price. ETFs were mostly exempt from the SEC's original short sale rule, called the uptick rule, which was revoked in 2007. But leveraged inverse ETFs were then very new; they have now grown to represent nearly 3 percent of all U.S. ETF exposure, according to Barclays. The SEC, now back at the short sale drawing board, is seeking public comment on five proposed rules, which include circuit breakers and a modified uptick rule. One question in its 273-page document asked specifically whether ETFs should be exempt. "We don't think it's necessarily a healthy thing to be putting those types of restrictions on market price discovery," said Andy O'Rourke, senior vice president at funds provider Direxion Shares, which in November was the first to offer triple-leveraged "bear" ETFs on financials and other sectors. "We're expanding. We generally believe that we'll be able to operate as we have in the past," O'Rourke said in an interview. "They (the SEC) could put restrictions on the way our products operate, in which case we would be concerned." Direxion, managed by Rafferty Asset Management, had about $3 billion in ETF assets under management at the end of the first quarter. O'Rourke said the SEC did not ask extraordinary questions when Direxion applied to register its latest funds. Industry leader ProShares, which introduced leveraged inverse ETFs in 2006 and now provides the double-leveraged UltraShort products, as well as smaller rival Rydex, both declined to comment. Its UltraShort Financials ETF gained 12.3 percent in just one day on Tuesday as financial stocks dropped, while its UltraShort real estate ETF rose almost 16 percent. Some industry observers say the triple-leveraged inverse ETFs may run into problems as the SEC evaluates its options, but most of those interviewed said double-leveraged inverse funds should remain untouched. Compounding the questions, the SEC hasn't defined the problem that needs solving, said John Standerfer, executive vice president of financial services at Austin, Texas-based consulting firm S3. "The leveraged ETFs, in my opinion, are not driving the stock prices of the underlying stocks that make them up," Standerfer said, noting restrictions on the underlying securities will affect the ETFs anyway.