Feds Back To Loving A Well Run Lottery

May 04, 2017

Oftentimes I walk into my local Chevron and it resembles more of a casino than a gas station. If it’s late Wednesday afternoon, and Powerball is grabbing record-jackpot headlines, the lottery ticket gamblers outnumber the gasoline customers.

Once I witnessed one man buying $250 in Powerball tickets, run by a multistate government gambling organization, and not purchasing gas or anything else. All forms of governments approve of this ability to lose money and we all accept this as free will. This is America: You can put money down at your gas station on a bet with astronomical odds of winning.

Surely the Securities and Exchange Commission knows about the $75 billion to $100 billion that Americans spend on lottery tickets sold by state governments, but that’s not a security, so that’s not the SEC’s table, so to speak. And that’s a good thing. How you spend your money is a form of free speech. The Supreme Court has ruled as such when it comes to political spending.

So Why The Rolling Eyes?

So news this week that the SEC approved an ETF issuer’s request to offer quadruple-leveraged exchange-traded products was funny to me, in a Chevron standing-in-line way. We’re talking “4X” daily exposure versus the already-listed “3X,” “2X,” 1X,” triggering rolling eyes in the financial blogosphere and Finance Twitter.

“Oh my … people could lose money with this product!” Hmmm, imagine that.

According to the Reuters story, the request to the SEC detailed two strategies to be listed on NYSE Arca, the ForceShares Daily 4X US Market Futures Long Fund, under the ticker 'UP,' and the ForceShares Daily 4X US Market Futures Short Fund, under the ticker 'DOWN.'

“'UP' is designed to deliver 400% of the daily performance of S&P 500 index futures, while 'DOWN' aims to deliver four times the inverse of that benchmark,” Reuters reported. “That means 'DOWN' could go up 8% on a day the index it tracks falls by 2%.”

Speculation Is Speculation

Outside Financial Nerdville, this doesn’t move the meter. Most American investors don’t know what an ETF is, much less an inverse/levered exchange-traded product based on futures. I think of these products as lottery tickets, but with much greater chances at winning than Powerball.

The day after the May-The-4XForceShares-Be-With-You broke, ETF issuer Direxion launched a series of new and novel leveraged funds. From our Daily ETF Watch yesterday:

Direxion has added another five ETFs offering 300% of the daily return of their underlying indexes. The five funds cover Mexico’s market and four key industries. The funds and their expense ratios are as follows:

 

Isn’t speculation just speculation? 3X or 4X, or a lottery ticket? For years we’ve seen these ETFs come to market—there are 271 leveraged and inverse ETFs offering various “geared degrees,” and everyone is OK with it.

I had a hard time finding anyone writing on these products that are now on the market, but the “4X” drew the critics. Here’s a sample from well-known financial writer Phil Huber, whose opinion was far more blunt: “capital destroyers,” he called these strategies. From his piece, “These Go To Four,” on bpsandpieces.com:

That’s right, the investment industry’s version of the infamous Spinal Tap amp is not far away. So-called “geared” ETFs are nothing new, as there have been funds providing leveraged and inverse exposure to various asset classes and market segments for over a decade now. First came 1x, then 2x, then 3x…and here we are today.

Make no mistake about it, these products are nothing but capital destroyers for investors. Notice I said investors, not day-traders. If you are buying and holding geared funds for a significant period of time, you are virtually guaranteed to lose a substantial portion of your investment. It doesn’t matter if the particular fund is leveraged, inverse, 2x, 3x, or now even 4x. Any way you slice it, you lose over the long-term.

SEC Change Of Heart?

The problems with leveraged/inverse products are contango decay, where the slow drip of costs from consistently buying more expensive front-month futures contracts sinks you, and the daily-reset math gobbles up your money. If you don’t know that, you should read the instructions.

Just like you can use a staple gun to shoot a nail through your foot, you can also use it to build a beautiful house, depending on how you read the instructions. There is the correct way to use a tool, and the dangerous way. All about free will, right?

I am pretty sure if I interviewed everyone single person ahead of me at Chevron buying Powerball, they would tell me they expect to lose. Expectations are low; hope is high and whimsical.

But what is unusual in this SEC approval of a 4X-geared (term for “levered and inverse”) products is that this is signaling a change of heart at the SEC. Here’s your Trump impact onto the U.S. ETF industry.

 

SEC Had Targeted Levered/Inverse ETFs

Just some 100 days ago, the SEC was run by Mary Jo White, who kept ETFs high on her radar, and had added regulations and even warnings on 3X-type ETFs during her tenure under President Obama. She was vocal about the risk associated with these securities (SEC Chief Set To Review ETF Regulations 5/23/16).

Earlier in December 2015, the SEC called out geared ETFs, from our story then.

“The Securities and Exchange Commission made a bold move today, proposing new rules on the use of derivatives in 1940 Act funds that would directly impact leveraged and inverse ETFs.

Leveraged and inverse ETFs seek to go up or down in value based on some ratio to an underlying asset (the gearing) over a particular time period that’s typically one single day. That “gearing” is achieved through the use of various derivatives contracts such as swaps and options—vehicles known to lack transparency and carry significant risk.”

Trump Has Arrived

Now, this is my opinion and mine alone: This move by the SEC was the first sign in the ETF industry that the anti-regulatory Trump administration is not going to stand in the way of reasonable products, especially ones that are very similar to already-approved securities. Reasonable, of course, is a concept open for debate.

Does this mean the Ham Sandwich ETF (HAM) is not far off? Not really. But it could be a new wave of thinking when it comes to the SEC and ETFs.

For instance, what appeared to be a perfunctory re-examination of the Winklevoss Bitcoin Trust (COIN), which would be the first bitcoin ETF in the U.S., doesn’t seem to be so routine now. What’s the difference between making a triple-leveraged bet on the peso and buying some bitcoin, both through ETFs?

Maybe I’m jumping to conclusions, or maybe this is a return to consistency when it comes to the American idea of “buyer beware.” I’ve never seen the SEC warning Powerball ticket buyers in my Chevron. Federal, state and local government shouldn’t prevent you from legally losing your money. And who knows, a Powerball ticket or a 4X ETF play may just turn out to be your winning bet.

Drew Voros can be reached at [email protected].

 

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