SEC Sends Mixed Signals About Cutting Edge ETFs

The Securities and Exchange Commission has been sending some mixed messages to the ETF market lately, reminding folks involved with this industry that regulatory risk is real.

First, the commission turned down all efforts to bring to market the bitcoin ETFs earlier this year—some of which had been in the pipeline for three years—just to have that rejection reopened for review in an appeal. That appeal is still ongoing.

The SEC then approved a request proposing the launch of a pair of ForceShares 4x leveraged and inverse ETFs for the first time, just to have that approval roadblocked pending additional review.

The regulatory guidance has been confusing, to say the least, generating a barrage of headlines. It has also cast a shadow onto the perception that the SEC, under the current administration, was going to be more flexible and open to innovation.

Flip-Flopping Decisions

Although there’s been no official statement to that effect regarding ETFs specifically, regulators have suggested flexibility would be an underlying theme with the commission going forward. So what’s with the flip-flopping regarding ETFs that attempt to go where none has gone before? (SEC declined to comment for this story.)

The truth is we don’t really know. And we don’t know if reviewing these recent decisions will eventually mean bitcoin ETFs will come to market and 4x leveraged funds will be stashed away for good.

But we can at least try to clarify some key points with the help of industry experts.

Bitcoin ETFs: The Rare Official Denial And Appeal

It’s rare to see the SEC actually issue an order rejecting a change request or exemptive relief as it did for bitcoin ETFs in registration, according to Jeremy Senderowicz, partner at Dechert—a law firm highly involved with the ETF industry. Appeals on those decisions are even rarer.

Typically, when regulators are going to say no to an ETF petition, the SEC tends to informally communicate with those making the petitions, and the involved parties pull the application before it’s formally turned down.

What happened to the bitcoin ETFs is rare, and it could suggest that a decision on these ETFs really came down to the wire. Perhaps there was not a lot of time for informal conversations.

If the commission was that conflicted with the idea of bitcoins in ETF wrappers in the first place, it may be difficult to imagine it will find enough peace to reverse its ruling a second time around.

But those involved with these ETF requests are hopeful, and the bitcoin market has been rallying un-phased.

“We’d like the SEC to show more flexibility with bitcoin, and we didn’t think the SEC’s rejection was justified,” said Senderowicz, whose firm is involved with the SolidX Partners’ bitcoin ETF efforts. “On what they are going to do, however, we don’t have any information.”

4x Leveraged ETFs: The Problem Of Perception

The case of the 4x leveraged ETFs is another story. As regulators review their decision, consider that these 4x leverage ETFs are unique, reaching into different divisions of the SEC than most ETFs do.

The SEC proposed a rule in 2015 aimed at limiting the use of derivatives in ETFs, discouraging their use, which impacted leveraged and inverse ETFs directly. According to Reuters, the original approval of 4x leverage ETFs suggested that effort “may be essentially dead.”

The SEC’s Division of Investment Management also had put a moratorium on granting exemptive relief to allow more people to offer these types of ETFs, Senderowicz notes.

But that moratorium never applied to funds that were not ’40 Act funds. The ForceShares ETFs are not ’40Act funds. In other words, they are not subject to the Division of Investment Management.

The registration statement must be approved by the Division of Corporate Finance, and because of the nature of the ETFs, the SEC also had to have a rule change approved by the Division of Trading and Markets in order to list it.

“Most of the controversy over the leverage and inverse ETFs has dealt with ETFs that were ’40 Act funds,” Senderowicz said. “These ETFs are not.”

To end investors, the who’s who in the roster of SEC divisions may not matter, but information is always helpful. What’s going on with the 4x leveraged ETFs in this case may not imply there’s a change of heart at the SEC regarding previous rulings on use of derivatives in ’40 Act Funds, as some suggest. At least, not yet.

“If they are reviewing the order, that’s not a great sign,” Senderowicz said of the prospect for these 4x ETFs. “To the extent we know anything, they expressed interest in granting people more flexibility to offer products, but we don’t know if this one is going to be one of the ones where they show flexibility. It may be too controversial.”

Bad Press And Perception

The initial approval of the ForceShares 4x leveraged and inverse ETFs could be interpreted as the work of a more lenient SEC under a Trump administration.

But news of the approval made headlines in every major financial media outlet, and not in a flattering light. The level of risk associated with hyped-up leveraged funds was called into question.

“Bad press is bad press, and it might have overwhelmed regulators,” Bloomberg ETF Analyst Eric Balchunas said of the commission’s decision to review its original ruling.

But what’s interesting about that is the matter of perception. Just how risky are 4x leveraged ETFs, and just how much protection do investors need from themselves?

The proposed ForceShares strategies would offer 4x leverage and 4x inverse on the S&P 500, “and people forget how much little volatility the S&P actually has,” Balchunas said. The proposed funds, the ForceShares Daily 4X US Market Futures Long Fund (UP) and the ForceShares Daily 4X US Market Futures Short Fund (DOWN), would deliver 400% of the daily performance of S&P 500 Index futures and four times the inverse of that benchmark, respectively.

4X Not That Volatile

“A 4x S&P 500 ETF wouldn’t even crack the top 150 most volatile ETFs,” Balchunas added. “Our society has it wrong: It’s optics versus reality. And whether it’s the Fed, the SEC or other government agencies, they are concerned about optics. The reality is that there are hundreds of faster ways to make or lose money with ETFs.”

The bigger risk is among the wolves in sheep’s clothing. The “innocent”-sounding United States Oil Fund (USO), which has roll costs that are 30-40% a year is an example, he says. “It will eat you alive, and yet it sounds innocent. In my opinion, that’s a more dangerous product.”

At the end of the day, it’s about knowing what you are getting into.

“A 4x ETF could be useful to a certain clientele,” Balchunas said. “If you look at trading volume of leveraged ETFs, they tend to have a lot more turnover than other ETFs, like 30-40% a day. That’s a sign people are using them right. If they were only turning over 1% a day, that would indicate a lot of buying and holding, and leverage ETFs are not meant for long-term holdings.”

“How do you make sure the right products get to the right investors? There are cases when that doesn’t happen,” he added. “But I see investors smarter than the media gives them credit for, and as far as leveraged ETFs go, they are a wolf in wolf’s clothing.”

“It looks like all the bad press forced the SEC to ponder the dark side of the ForceShares,” Balchunas added.

Contact Cinthia Murphy at [email protected]