On Wednesday, the Securities and Exchange Commission (SEC) passed a controversial new rule that, among other things, would make it significantly easier to launch leveraged and inverse exchange-traded funds, but at smaller multipliers than previously approved.
Rule 18f-4 would allow ETFs and other funds that aren't explicitly allowed by the Investment Company Act of 1940 to use derivatives, without first having to obtain exemptive relief. New ETF launches may now apply up to a 200% multiplier, either long or inverse, on their underlying indexes.
In addition, all existing exemptive relief orders regarding fund use of derivatives have been rescinded—meaning that, so long as issuers comply with this rule and the ETF Rule, they can launch leveraged/inverse ETFs using the same process used for most other ETFs.
The changes go into effect 60 days from Wednesday.
Few Leveraged/Inverse ETFs, Plenty of ETNs
Rule 18f-4 impacts leveraged and inverse ETFs specifically because these funds use derivatives to build geared exposure to underlying indexes. This wasn't allowed by the '40 Act, however, so would-be issuers of leveraged and inverse ETFs have had to first gain exemptive relief orders from the SEC—and the agency stopped granting these orders back in 2012.
Until now, only Direxion and ProShares had been granted the necessary exemptive relief to issue leveraged and inverse ETFs. (A handful of other ETFs from AdvisorShares and Virtus also implement leverage, but in a much different context: Their portfolios are not primarily constructed from derivatives based on indexes, for starters.)
However, while leveraged/inverse ETFs have been few and far between, many banks have provided geared exposure in the form of exchange-traded notes, including Barclays Capital, BMO, Citigroup, Credit Suisse, Deutsche Bank and UBS.
ETNs differ from ETFs in that they do not hold securities; an ETN is simply a debt note tied to the return of an index—or in this case, a daily multiplier of an index. (Listen: "Fact Vs. Fiction In Leveraged ETFs.")
Investors Flock To Leveraged/Inverse ETFs In 2020
Historically niche products used by hedgers and short-term tactical traders, leveraged and inverse products have seen a substantial influx of investor cash since the COVID-19 pandemic began.
Together, leveraged and inverse products have brought in $15.3 billion in 2020 year-to date, the greatest amount of new assets that geared ETFs have seen in roughly 10 years.
These flows have been driven largely by retail investors, including the so-called Robinhood trader, looking for ways to juice their returns in a down year. (Read: "Robinhood's Favorite ETFs.")
But leveraged and inverse products also have experienced wild swings, and dozens of the products have closed so far in 2020, particularly ETNs tied to energy indexes. (Read: "Leveraged & Inverse ETN Extinction.")
New Rules For Leveraged/Inverse ETFs
Under the new rules, the SEC would allow ETFs and other funds to use derivatives, as long as they comply with certain investor protections.
That includes the adoption of a derivatives risk management program, administered by a dedicated risk manager and overseen by the board of directors. They will also have to carry out certain fund reporting and recordkeeping requirements surrounding their derivatives use.
Notably, the final rule also introduces a cap on how much leverage a fund can take on, based on value-at-risk (VaR), a statistical measure of the risk of loss for a given investment.
Downshifting Geared Caps
Intriguingly, the SEC affords funds significant flexibility regarding which benchmarks VaR may be referenced to, allowing a fund to benchmark to a portfolio of its own nonderivatives securities. (The original proposal stipulated that risk be compared to a “designated reference index” that couldn't be administered by the fund or any of its affiliates.)
In practice, these leverage caps effectively limit new funds to a multiplier of 200% or -200% the daily return of the underlying index. (This is lower than the original proposal, which would have capped leverage at 300%/-300%.)
Existing leveraged/inverse ETFs with higher leverage factors than 200% are left unaffected, but they may not raise their leverage caps any higher, said the SEC, nor may they change the underlying index to which their leverage is applied.
Controversial Sales Practice Plan Scrapped
As proposed, Rule 18f-4 also would have required brokers and registered investment advisors to first evaluate and approve retail clients' accounts before letting them trade leveraged/inverse ETFs.
However, the proposed sales practice rule was scrapped after it proved highly unpopular with commenters. Of the more than 6,000 comment letters the SEC received on its derivatives proposal, 99% of them pertained to the sales practice rules, urging the SEC to reconsider.
Ultimately, the SEC argued in its rule that Regulation Best Interest and the fiduciary obligations of advisors would help to address the sales practice concerns the agency had, though the SEC is also conducting a review to evaluate investor safety in situations where retail investors trade leveraged/inverse products outside an advisory relationship.
They will also seek further comment from the public on how best to regulate the sale of complex products, such as leveraged and inverse ETFs.
Only The ‘Appearance’ Of Action?
Now that issuers can use Rule 18f-4 in conjunction with the ETF Rule to issue leveraged and inverse ETFs, we will likely see new products and new issuers entering the ETF market, just as the ETF Rule opened the floodgates for boutique firms and active managers.
But not everybody is happy with the new rule.
Joseph Cisewski, senior derivatives consultant and special counsel for Better Markets, said in a statement: "Undeniably, the SEC missed an opportunity to enact meaningful constraints on derivatives-related leverage in mutual funds. For example, the SEC's over-reliance on value-at-risk (VaR) measures will not fully address leverage concerns or derivatives risk," adding that "the finalized VaR measures may have been calibrated specifically to avoid limiting leverage and derivatives risks in mutual funds."
"The SEC may have built an elaborate derivatives framework designed to give the appearance of taking meaningful action without actually doing so," he continued.
At least one SEC Commissioner agrees. Commissioner Allison Herren Lee wrote in her dissent on the rule's passage that "the final rule … abandons much of what made it a reasonable, balanced approach, one that garnered it a 5-0 vote last year."
Contact Lara Crigger at [email protected]