“I’m fixing a hole, where the rain gets in.
And stops my mind from wandering.
Where it will go.”
– Fixing a Hole, The Beatles
This morning’s Wall Street Journal has a piece covering ProShares response to the SEC’s proposed derivatives rule. It should come as absolutely no surprise that ProShares is against the rules, but what is a little surprising is that they’re making a public plea to shareholders to put their black marbles in the goldfish bowl to help kill it.
Why should you care? Because regulation, while boring, matters a lot to end investors, and bad regulations are always bad for investors.
So what’s really going on here?
The History of Clogged Pipes
The use of leverage to juice your returns is hardly new, and concern for the average investor (or in this case debtor) goes back to Deuteronomy. In the more modern ETF context, the first funds we’d recognize as geared showed up in the mid 2000s, and by 2010, the SEC started growing concerned investors might not know what they were getting into with funds from ProShares and Direxion. The concern wasn’t unreasonable: ETFs are for the most part bought, not sold. Since the 1980s, most individual investors have accessed the markets either indirectly through retirement plans, or through self directed brokerage accounts where they can buy Mutual Funds, ETFs, and individual securities. Let’s skip the retirement market for the moment, as I have never heard of a single 401(k) plan offering up triple leveraged anything as an option.
So really, this is all about either an individual stumbling into a high-risk product “by accident,” or some financial advisor putting their clients inappropriately into a short-term trading vehicle. And that did happen back in the 2000s. When the geared products first hit the street, as long as you could find a ticker, you could buy a fund. This came to a head in 2009 when a class sued ProShares when one of its real estate funds did exactly what it was supposed to do, but produced a result unanticipated by some reading-challenged investors. That case was dismissed in 2012 (it really was really without merit, because all the risks were disclosed in the registration statements, as they should be.)
But between the lawsuit and the dismissal, regulators got antsy and (in my never-very-humble-opinion) appropriately applied some brake pressure. I attended countless “lunch and learns” with various regulators where the hand wringing was severe and sweaty palmed, but in the end, FINRA (who regulates brokers) put out guidance saying (in a nutshell), “Hey guys, maybe you should have some additional disclosures, say, at the point of sale, so investors know there’s a difference between geared and non geared funds! And please keep track of how you implement that okay?” The SEC, for its part, just shut the whole product segment down. They let the existing products stay alive, but they put a kibosh on any new firms coming to market with geared funds in 2010.
And honestly, that’s been the state of play for a decade. A few products that use derivatives as a primary strategy (notably defined outcome products like those from Innovator) have snuck through, but that’s pretty much it. And it’s worked. You basically cannot buy a geared product as an individual now without going through a screen like this (from my Schwab account).
And what’s more, even after you say “yes” most firms make you reaffirm “I get it” at least yearly, if not every time you trade. Despite some pretty harsh things I’ve said about geared funds in the past, this is really all I ever advocated for: the proactive, point-of-sale “I get it” affirmation.
But just because the industry backed itself into the right solution doesn’t mean the SEC can just move on to arguing about Bolivian wheat futures or the Cryptopocalypse. They created a real jam for themselves when they simply stopped reviewing new funds. They created a duopoly, without actually doing a darn thing to fix the now-fixed “problem.” So they have to make some kind of a rule.
The key issues at work here are really quite simple:
1: The bucket – in other words, to what funds does the new rule apply.
2: The actual rules – that is, if you’re in the bucket, what do you have to do to be in compliance
In 2015 they took their first tilt at this windmill of their own creation. The “Bucket” definition was not great – it required the establishment of a host of measurements that really aren’t standard practice at any firm, and would have created all sorts of interesting loopholes. And the “Rules” part was complicated, building a new risk management regime and requiring the redefinition of a bunch of forms fund managers send to the SEC regularly. Notably, it didn’t actually change much from the investors perspective, it was just a set of operational requirements and caps. It would have been a particular form of hell I like to call “unproductive bureaucracy.”
The new rule proposal, which first floated in November of 2019, changes a few things.
First, the “bucket” definition is better, in that it creates two distinct classes of funds, those that choose to pass a Value-at-Risk calculation (the max loss expected over 20 days with a 99% confidence level) of 150% vs. a reference index. In actual human language, that means a fund would run some math on, say, the S&P 500 that returns “99% of the time, over the next 20 days, you could lose $100 of your $1,000 investment.” The fund would then run a VaR calculation on the fund itself, and as long as the result was less than “99% of the time, over the next 20 days, you could lose $150 of your $1000 investment” you’re in the bucket.
These kinds of calcs are cool, because they don’t require anyone to even know how the fund is getting its exposure, whether it’s through margin or options or swaps or whatever, it just focuses on the likely outcome. That’s great, because it means, for instance, an active manager could fall under the rubric. But it also sucks because it doesn’t address the 1% of the time you could lose more than the amount spat out by the math, and you could end up with some interesting tail-risk issues. (I also worry it could be gameable through things like Cayman Island subsidiary investment, but I honestly haven’t spent enough time with the lawyers to know if I’m wrong about that yet.)
The other bucket definition – and the one most relevant to the existing product providers – is a simple “300% exposure vs. a reference index” cap. That’s nice and simple, and certainly applies the vast majority of use cases in the ETF sphere.
Are there issues here? Sure. VaR testing requires either that history repeat itself (because there’s no such thing as a time-travel dataset) or it requires that security returns are normally distributed (which they honestly never really are). But from an ETF perspective, this isn’t much of a big deal because, like I said, I expect most of the existing products will fall under the 300% bucket definition.
So now we have the better, reasonable, but not perfect bucket. So now what?
That’s where things get hairy.
Here’s what they SHOULD have done. Standardize industry best practices.
The industry has been mostly a Boy Scout in terms of disclosure since 2010. The fund companies have diligently put all the risks in their filings and on their websites and all over their marketing materials. There is no fund company in the world saying “Hey Grandma, how bout some sweet triple leveraged inverse oil futures for your retirement income stream.” They don’t want Grandma’s money. And the brokers, as I pointed out, solved this at the point of sale. Class action lawyers keep trying to drum up cases against the current geared providers and, as recently as a few weeks ago, rational judges keep tossing the cases out.
But that’s not what’s being proposed. Instead, every person who wants to buy one of these products will have to fill out a long-form questionnaire that includes a lot of quite personal information I’m not necessarily sure I even want to tell my broker: income, net worth, employment status and so on. Honestly, why is it Schwab’s business if I’m an unemployed millionaire or a hard working pauper? I’m not claiming to be an accredited investor looking to tie up money in a private placement for a decade. Just let me acknowledge the risks.
To make matters worse, it doesn’t matter one iota if I have a financial advisor. Now look, I get it, not a lot of financial advisors are out there day-trading leveraged funds. But that doesn’t mean there’s no advisor on the planet who might, for instance, want to use an inverse fund as a short term hedge against an upcoming employee-stock option payout to a high net worth client. And those kinds of more sophisticated strategies are completely covered by the recently passed Reg BI which goes into effect in June of this year. No advisor is going to want to haul his client in to fill out yet another pile of physical paperwork just to make a simple hedging trade.
The good news is that this is totally salvageable, and honestly, even the SEC commissioners know it. In a fairly unprecedented move, two of the commissioners (also Republican appointees, like Chairman Clayton) posted a pre-rebuttal to the rule. It’s a good read, honestly, I recommend it. Their main talking point is that yeah, it would be great to break the logjam on new product innovation, and to allow these funds to lean on the recently passed (and mostly awesome) ETF Rule 6c-11. But they (like me) argue that this is an over-reach, and pretty unprecedented in the history of investor protection regimes.
ProShares stance here is that the whole thing should be lit on fire and tossed in the trash can. While I understand and respect their opinion here, I can’t get behind it. The SEC painted themselves into a corner and so they have to do something. If the SEC can step back and take a look at how the market already solved the problem, they can close the gap.