By Jessica Toonkel

HOLLYWOOD, Florida (Reuters) - Exchange-traded fund providers agree that they need to do more to make sure investors understand what they are buying when they invest in an ETF. But the details of how to do that was the subject of debate at IndexUniverse's Inside ETFs Conference.

With almost 1,400 ETFs available in the United States and another 900 filed as future offerings with the U.S. Securities and Exchange Commission, an increasing number of niche and complex ETFs are coming to market. Providers and regulators are worried that investors may end up buying products they do not understand.

The fund companies that offer ETFs worry most that just one bad situation could result in a lawsuit or investor outcry, creating a wave of negative press for the $1 trillion industry.

"I always worry about the reputation of the industry," said Bill Belden, managing director, head of product development at Guggenheim Investments. "All it takes is one issue to create a shadow on the entire industry."

In the last several years there have already been instances where brokers sold long-term investors leveraged and inverse ETFs, which are designed for short-term, professional traders.

Many ETF providers worry that if they do not come up with a solution, and another scandal hits the ETF industry, regulators will create rules that could ban the sale of certain types of ETFs to retail investors or even forbid ETFs to use certain kinds of instruments, like derivatives.

The SEC already is reviewing the use of derivatives in ETFs and is not approving any new ETFs that use derivatives.

"I am worried that if there is regulation, it won't be flexible enough to allow for the next innovative type of ETF to come to market," Jim Ross, head of ETFs at State Street Global Advisors, said in an interview at the conference, held in Hollywood, Florida.

The concerns stemmed from the perceived role of ETFs in the May 6, 2010, "flash crash." Since then, regulators have been scrutinizing whether ETFs are contributing to extreme swings in the market, namely whether high frequency traders' use of ETFs caused much of the volatility in markets last year.

Regulators have issued a string of warnings around the sale of leveraged and inverse ETFs, which are designed to amplify short-term returns by using derivatives. In October, the SEC announced a broad review of ETFs to ensure their transparency.

Industry executives at the three-day conference grappled with two main proposals aimed at keeping investors from buying into funds they don't understand: stripping the ETF label from more complex products and restricting who can invest in more complex ETFs.

NEW NAMING

The first was initially proposed at congressional hearings in October. At the time, iShares, the ETF division of BlackRock Inc, suggested a new classification system for the fund set that would not allow complex products that rely on derivatives to use the ETF moniker.

"We want to make sure that ETF investors understand exactly what they own," Darek Wojnar, managing director at iShares, said in a panel discussion on Monday.

But iShares' proposal has been met with much pushback from a number of ETF providers who feel that a new classification system would cause more confusion among investors.

"There are over 7,000 mutual funds and they have complex products and don't need a classification system," State Street's Ross said in an interview with Reuters at the conference.

iShares is discussing the idea with other ETF providers and the Investment Company Institute, the trade group for mutual funds and ETFs, but is open to a compromise, Wojnar said.

RESTRICTING ACCESS

The idea some industry officials are floating would require the financial advisory firms to restrict the sale of complex ETFs only to sophisticated investors.

Currently, a number of brokerage firms act as "gatekeepers," determining who can buy leveraged and inverse ETFs. Many brokerage firms stopped selling such ETFs when regulators began citing concerns in 2009. Most have started to sell them again but with restrictions around who can buy them, said Dave Nadig, director of research at IndexUniverse.

A wider use of this gatekeeper model was an idea industry executives discussed at the Florida conference. One option would be to have investors sign a form saying they understand the risks before buying more complex ETFs, Nadig said. A more extreme alternative: brokerage firms could be forced to only sell complex ETFs to institutional or professional investors.

"This would have to come from FINRA (the independent brokerage regulator) working with the SEC," Nadig said. The industry is generally opposed to official regulatory solutions.

But since ETF companies can't seem to agree on one strategy, regulators might be forced to step in, Nadig said.

"A voluntary classification means everyone has to be on board for it to work and that's not going to happen," he said.

(Reporting By Jessica Toonkel; Editing by Jennifer Merritt and Tim Dobbyn)