Morningstar may stop rating leveraged, inverse ETFs

CHICAGO (Reuters) - Morningstar (MORN.O) is likely to remove leveraged and inverse exchange-traded funds from its influential star-rating system and track them separately from its standard fund categories, an executive with the fund research firm said in an interview.

Scott Burns, director of ETFs at Morningstar, said the products are intended for traders while his firm is oriented more toward long-term investing.

"We've gotten some complaints," Burns told Reuters after speaking at Morningstar's ETF conference in Chicago on Friday. Brokers and others who pay Morningstar for access to its database have told the firm "we don't want our investors stumbling on these things when they are screening for regular funds," Burns said.

Leveraged and inverse ETFs typically move in the opposite direction of a market index basis or in multiples of an index's performance. Because of the effect of compounding, the funds do not track index returns over longer periods, which has confused some investors and drawn attention from regulators.

Only a handful of leveraged ETFs carry star ratings in Morningstar's widely followed fund database because most have not been in existence for three years, a requirement for receiving a rating.

Those that are included are rated 1-star, Burns said. But dozens more of such funds managed by ProFunds Group under the "ProShares" brand name and founded just under three years ago are about to qualify, he said.

UNDER FIRE

Morningstar's expected move makes sense and should reduce investor confusion, said Matt Hougan, editor in chief of the ETF-oriented web site Indexuniverse.com. "There's no way to fit these into a star rating system that's based on long-term performance," he said.

The funds generally perform as advertised and expected. But after a day with a steep gain or sharp loss, a leveraged fund's asset value has changed by more than its index so the effect of compounding returns over subsequent days can have a greater or lesser impact.

For example, the ProShares Ultra S&P 500 ETF (SSO.P), designed to gain twice as much as the index on a daily basis, has lost almost 1 percent in price so far in 2010 while the S&P 500 is up about 0.12 percent.

The ProShares Short S&P500 ETF (SH.P), intended simply to move in the opposite direction from the index on a daily basis, has lost almost 5 percent.

Leveraged ETFs came under fire from consumer watchdogs and some regulators because unsophisticated investors were confused about how the funds operated.

Last year, the Securities and Exchange Commission and Finra, the brokerage industry's self-regulatory body, warned firms to ensure that customers buying leveraged ETFs were not intending to hold them as long-term investments.

"Inverse and leveraged ETFs that are reset daily typically are unsuitable for retail investors who plan to hold them for longer than one trading session, particularly in volatile markets," Finra wrote to its member firms last June.