Exchange traded funds that utilize derivative financial tools to achieve their intended strategies have drawn greater scrutiny from regulators. However, the investment vehicles have been working as intended for more sophisticated investors whom understand the tools.
Analysis of their market activity illustrates that leveraged exchange-traded funds have been used properly since they were registered in 2006, serving their intended purpose for suitable investors. Leveraged and inverse ETFs utilize derivatives contracts to enhance daily index returns. For instance, most leveraged ETFs are designed to produce double or triple the performance of the underlying market on a daily basis while inverse options reflect the opposite moves to a benchmark. Suitable investors who understand the risks associated with daily leveraged investment results should be willing to actively monitor their investments. Many investors who have utilized leveraged or inverse strategies to hedge their portfolios have looked to Direxion or ProShares ETF options for magnified equity or bond exposure.
Trading activity in leveraged ETFs have been consistently high compared to other types of ETFs, which suggests that tactical short-term traders are often those who utilize the geared products. For instance, the popular ProShares UltraShort 20+ Year Treasury (NYSEArca: TBT), which has $2.7 billion in assets under management, has an average daily volume of 2.8 million shares, according to Morningstar data.
In the wake of the 2008 financial downturn and subsequent environment of heightened volatility, the Securities and Exchange Commission began reviewing derivatives usage in mutual funds, ETFs and other investment companies to determine whether additional safeguards are required. [Derivatives-Based ETFs Await SEC Decision]
While the SEC originally implemented a moratorium on exemptive relief requests for new leveraged ETFs and others that used derivatives, regulators partially lifted the moratorium on actively managed ETFs but left the ban on leveraged ETF requests. [SEC to Lift Freeze on Active ETFs That Use Derivatives]
As leveraged and inverse ETFs gain in popularity, or notoriety, the industry has stepped up education on the products, highlighting the fact that these leveraged vehicles reset on a daily basis and the compounding effects could cause the returns of ETFs for periods greater than a day to diverge from their intended daily objectives, especially during volatile market conditions. [Do You Know How Your Leveraged ETFs Work?]
The ETF industry’s aggressive educational outreach has been emphatic towards investor suitability – these funds are not suited for long-term, conservative investors who prefer a buy-and-hold approach. Leveraged products have been used properly since their inception, serving as effective financial tools for the individuals who understand these trading instruments and want to act on a short-term active view of the markets.
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.