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.
If approved, these rules would cause a large number of geared ETFs to shut down—a consequence SEC Chief Economist Mark Flannery acknowledged. By a vote of 3-to-1, the new rules were approved to enter a 90-day public comment phase before a final decision is made.
The proposed regulation consists of three main points:
- It limits the amount of notional exposure to derivatives a fund can have to 150% of a fund’s net assets for most funds, or to 300% if the fund actually offers lower market risk because of that notional exposure;
- It requires asset segregation for all derivative transactions. This essentially would require the fund to manage risks associated with derivatives by segregating assets this way: mark-to-market coverage amount, or the assets “equal to the amount that the fund would pay if the fund exited the derivatives transaction”; and risk-based coverage amount, or assets the fund would be required to segregate as additional “risk-based coverage representing a reasonable estimate of the potential amount the fund would pay if the fund exited the derivatives transaction under stressed conditions”; and
- It requires the implementation of a formalized derivatives risk management program administered by a risk manager.
In a webcast this morning, the commission was emphatic on its core goal; namely, to protect investors—particularly retail—who have come to rely heavily on 1940 Act funds for long-term investing, and who are the demographic leading the growth of these funds.
"Assuming the proposed rules are implemented as suggested by the SEC, it's a death knell for a big group of geared ETFs,” Dave Nadig, director of ETFs at FactSet, said. “While -1X ETFs would presumably be fine, any of the 2x and 3x products would have to either close for business or scramble for a new structure without these restrictions."
"That's not impossible—most commodities funds, for instance, are registered as commodity pools with the CFTC, and not subject to the rules just proposed,” Nadig added. “But moving structures is far from a simple form you fill out, and it remains to be seen how Direxion and ProShares respond."
Steve Cohen, managing director at ProShares, says it’s too early to react.
“At this time, the details of the rule proposed today are unknown and the regulatory process ahead will be long and its outcome uncertain,” Cohen said. “After we’ve had a chance to review the full text of the proposal, we will evaluate whether any changes in the management of our funds would be appropriate. Ultimately, we believe we will be able to continue to offer leveraged and inverse mutual funds and ETFs to help investors manage risk and enhance returns.”
At greatest risk are ETFs that go beyond 1x leverage. Double or triple leverage funds would most likely fail to meet position requirements—there are more than 200 funds commanding more than $42 billion in assets that fall into this category.
For a thorough explanation on what the fuss over derivatives is all about, see Nadig’s recent blog on ETF.com, “SEC Chases ETF Bogeyman: Geared Funds.”
Contact Cinthia Murphy at [email protected].