SEC Chases ETF Bogeyman: Geared Funds

December 10, 2015

This week, the Wall Street Journal wrote an article suggesting that the SEC might come out Friday and shut down all leveraged and inverse ETFs.

This would be a bold move for a regulator that, generally speaking, hates to actually disrupt whole product lines. After all, it's not like in 2008 when collateralized mortgage obligations and their derivatives ceased to exist; there were just new rules about who could issue them and how much risk they could take.

Regardless of what they do or don’t say this week, or next week, or next month, it’s worth understanding what all the fuss is about.

It’s really about swaps, investor education and volatility.

The Swaps

Leveraged and inverse ETFs (and exchange-traded notes) seek to go up or down in value based on some ratio to an underlying asset (the gearing) over a particular time period (typically one day.)

Imagine you want to be invested in the S&P 500. You could buy one of several S&P 500 ETFs. If you were really sure the S&P 500 was going to go up today, you could buy a leveraged S&P 500 ETF that would promise you 200% of the index’s daily returns. If the S&P 500 goes up 1% for the day, you’d go up 2%. If you were sure the S&P 500 was going to tank, you could make the opposite bet and buy an inverse-leveraged ETF that goes up when the index goes down.

If it sounds magical, it’s not really. Structurally, most of these funds are just 1940 Act-registered mutual funds, like Fidelity Magellen or the Growth Fund of America. But instead of owning stocks, they own just two securities: First, they own a giant pile of cash. Second, they own a swap contract on the S&P 500.

Swap contracts aren’t traded on an exchange, like options, so they’re considered “over the counter” or negotiated derivatives. The ETF issuer calls up a big bank, like Goldman Sachs, and says, “I would like to make a bet. Every day, if the S&P 500 goes up 1%, you give me 2%, and if GDX goes down 1%, I’ll owe you 2%.” Every night, the issuer and the bank check out who won the bet, and cash moves from one side of the betting log book to the other.

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