The U.S. Securities and Exchange Commission has spent the last four months probing how leveraged and inverse exchange-traded products could be more tightly regulated.
That isn’t stopping AXS Investments, a relative newcomer to the ETF issuer landscape, from filing to launch double-leveraged or double-inverse funds tracking some of the most volatile growth stocks on the market, applying leverage to the daily performance of a single company’s stock price.
While regulatory observers say it’s unlikely the SEC would outright ban AXS’ proposed funds, it may draw additional scrutiny from an agency operating under a tighter investor protection mandate.
Bull/Bear On Tesla, Nvidia & More
AXS’ first leveraged and inverse filings came late last month, seeking to double the daily performance of the ARK Innovation ETF (ARKK) and provide inverse exposure to the KraneShares CSI China Internet ETF (KWEB).
Those proposals aren’t too extraordinary in the broad scheme of the geared ETF world: A large number of funds use other ETFs to produce bull or bear bets on broad market or sector-specific indices like the S&P 500 or the Nasdaq-100. The concept of embedding options contracts into a fund tracking an actively managed ETF follows in the footsteps of the ARKK-inverse Tuttle Capital Short Innovation ETF (SARK), which debuted in early November.
But the latest batch of proposed funds from AXS on Thursday seek to establish doubled bull and bear returns on Tesla, Nvidia, ConocoPhillips, Boeing, PayPal, Wells Fargo, Pfizer, SalesForce and Nike.
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One of the core features of the ETF structure is diversification, smoothing out the direction of individual stocks affected by company-specific issues like management changes. The stocks AXS seeks to follow range from being up 14% in the case of Boeing to down 34% in the case of PayPal over the last month.
These products may find a following among the retail crowd, especially the set of newer, more aggressive traders who in part bought GameStop call options on Robinhood and other no-fee brokerages to ride last year’s short squeeze higher.
Todd Rosenbluth, the head of ETF and mutual fund research at CFRA, said the AXS funds may find a home among braver retail traders.
“Given the new wave of investors that came to the markets in the last few years for both stock and ETF exposure, there’s likely an audience for these products,” Rosenbluth said. “Hopefully that audience appreciates the risks, not just the reward potential.”
These filings come as the SEC continues to review potential market risks from complex exchange-traded products at Chairman Gary Gensler’s request last October. He also asked regulatory staff to present recommendations on how the SEC could tighten the rules around listing and marketing inverse and leveraged funds, fitting in with the theme of broadening investor protection since Gensler became the agency’s head.
The SEC declined to comment on the progress of its review, or when it expects to release its findings.
This isn’t the first time the SEC has examined the structure of inverse and leveraged ETFs. The Commission started publicizing the risks of levered products as far back as 2009, and examined ETFs more broadly in 2015.
This latest study is likely to focus on the Commission’s previous concerns, investor protection and systemic risks, said Elizabeth Goldman, a former SEC staffer and the director of the Securities Arbitration Clinic at the Benjamin Cardozo School of Law.
She expects that regulators will push AXS and other potential single-stock fund issuers to explain how they wouldn’t contribute to volatility or market manipulation situations, pointing to the 2008 Volkswagen short squeeze as an example.
“There's going to be a lot of pushback from the staff, and [issuers] are going to have to really explain how they're not contributing to market volatility,” she said.
While the SEC has been able to restrict cryptocurrency exposure in open-ended vehicles to only bitcoin futures, the same likely won’t come true for these or other boundary-pushing exchange-traded products regardless of how regulators feel about leverage in ETFs.
Andrew Davalla, a partner practicing securities law at Thompson Hine, said he wouldn’t be surprised if regulators asked AXS and other potential issuers to delay the automatic 75-day effectiveness date so it has more time to consider the novel strategy. He expects regulators to push AXS for as much disclosure as possible in its materials as to how the funds will act differently than regular ETFs.
“If you appropriately disclose that an investment can be very volatile, absent any other issues to me, that's not a reason for the SEC to stop a fund or withdraw a fund,” he said.