Exchange traded fund traders who have utilized leveraged and inverse products to hedge positions or capitalize on swift market turns will be watching the Securities and Exchange Commission this week as the regulatory body is set to make an announcement on the use of derivatives in fund products.
On Friday, the SEC is set to propose new rules on the use of derivatives, which are expected to have a large effect on the leveraged instruments that try to deliver two- or even three-times the returns of their benchmark indices, report Andrew Ackerman and Leslie Josephs for the Wall Street Journal.
Leveraged ETFs utilize financial derivatives and debt instruments to amply returns of an underlying index by minus 200% and 300% or positive 200% and 300%.
Regulators contend that these products commonly known as leveraged ETFs can be volatile and expose investors to sudden, outsize losses. [Do You Know How Your Leveraged ETFs Work?]
The SEC and the Financial Industry Regulatory Authority have previously warned that these “highly complex financial instruments… can differ significantly from their state daily objective,” reports Chris Dieterich for Barron’s. The SEC’s Office of Investor Education and Advocacy previously warned that leveraged ETFs may be “unsuitable for long-term investors.”
Friday’s proposal is expected to make it more difficult for certain funds to implement derivatives, though details remain unclear. The SEC has announced that it would vote Friday on new rules governing “the use of derivatives by registered investment companies.” While the market is still speculating on the details, fund companies like ProShares Advisors and Direxion Investments could be affected.
Direxion has 70 U.S.-listed ETFs that follow inverse and leveraged strategies. The sponsor provides some of the most popularly traded ETFs on the market. For instance, the $1.4 billion Direxion Daily Financial Bull 3X Shares (NYSEArca: FAS), which takes the triple-long daily performance of the financial sector, has an average daily volume of about 4.7 million shares. The $804.9 million Direxion Daily Gold Miners Bull 3X Shares (NYSEArca: NUGT), which takes the 3x or 300% daily performance of a group of large gold miners, has an average volume of 3.4 million shares.
ProShares offers 121 inverse and leveraged U.S.-listed ETFs. The firm is home to the largest leveraged ETF, the ProShares UltraShort 20+ Year Treasury (NYSEArca: TBT), which has $2.7 billion in assets under management and has been a go-to method for many traders to hedge against falling Treasury bond prices or rising yields.
Fund providers that offer leveraged and inverse products fear that any SEC rules governing the use of derivatives will effectively require leveraged ETFs to increase the amount of safe assets to counteract derivatives exposure. The funds would essentially be forced to increase exposure to low-risk, low-return assets, like cash and equivalents, which would impede their ability to provide outsize returns for those who understand the the risks.
Leveraged and inverse products only make up about 2% of assets in U.S.-listed exchange traded products. Meanwhile, net inflows into the sector more than doubled to $4.9 billion for the year ended October, compared to 2014. Investors funneled $181.2 billion into U.S.-listed ETPs this year.
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Max Chen contributed to this article.