Even before the advent of leveraged ETFs, the financial markets have implemented leverages in many investment instruments, usually at leverage points many times higher than what the ETF industry now offers. For instance, mortgage payers typically make a down payment at about 20% of a home’s value and borrow the remaining 80%, which represents a 5x leverage, and it is not uncommon for some homebuyers to finance at even higher ratios. On Wall Street, futures contracts on the S&P 500, which carry a 20x leverage point, are some of the most liquid and frequently used financial instruments, often filling a gap in a hedged investment portfolio and keeping the markets efficient.
More recently, some market observers contend that leveraged ETFs impose systemic risks on the market, especially during times of heightened volatility, such as the recent so-called mini flash crash. While some have been wary about how leveraged and inverse ETFs impact the financial markets as they rebalance portfolios, the concerns may be largely overblown.
In the wake of the mini flash crash during the height of the recent market volatility, the Securities and Exchange Commission is taking a closer look at safeguards to help obviate another wild swing in ETFs. The SEC will vote on proposed rules, which include a look at derivatives, requiring mutual funds and ETFs to better handle extreme volatility when investors execute heavy redemptions. Regulators will open the proposal to public comment and then vote on it a second time before its provisions go into effect. [SEC Aims To Secure ETF Trading]
The SEC has already proposed a rule to boost data the agency collects from asset managers. Future rules could include curbing fund use of leverage and derivatives and implementing stress tests similar to those in the financial industry.
Mike Piwowar, a member of the Securities and Exchange Commission, recently said that “a false narrative about leveraged and inverse ETFs” is being propagated by more conservative investors. Leveraged ETFs typically track large and liquid indices. Consequently, any liquidity needs are quickly met in the same way other index-based ETFs rebalance throughout the year, except leveraged/inverse ETFs rebalance on daily basis. [Concerns Over Geared ETFs’ Impact On Markets Are Overblown]
We anticipate a reasonable proposal from the SEC, one that clarifies derivative disclosure while preserving the benefits of these products for suitable investors.