Morningstar may drop star ratings for leveraged, inverse ETFs

Morningstar Inc., a Chicago-based research firm, may stop rating leveraged and inverse exchange- traded funds on a scale of one to five stars because of concerns about their suitability for individual investors.

The company is considering removing the ETFs from broader fund categories and putting them in a separate group, Scott Burns, Morningstar’s director of ETF research, said in a telephone interview. The change would also end the funds’ star ratings, he said.

“Star ratings are meant for investment vehicles and these are trading vehicles,” Burns said.

Leveraged ETFs use derivatives and debt to amplify the returns of a market index, while inverse funds profit from declines in an underlying benchmark. The Securities and Exchange Commission in March stopped approving new ETFs that make significant use of derivatives, in part to review whether individual investors required additional protections.

Unlike mutual funds, which can take deposits or make redemptions once a day, ETFs trade on an exchange all day like stocks. ETF assets grew 28 percent to $821.4 billion in the year ended July 31, according to the Investment Company Institute, a Washington-based trade group.

The SEC and the Financial Industry Regulatory Authority, the U.S. brokerage watchdog, told investors in August 2009 to be wary of leveraged and inverse ETFs, saying they may not be appropriate for long-term investors because returns can deviate from underlying indexes when held for longer than a day.

Institutional investors who buy and sell the products during a single trading session do most of the trading in the funds, Burns said.