U.S. regulators warned that leveraged exchange traded funds are a potential risk to the stability of financial markets and argued for strict rules to be applied on the more complex investment tool.
The Financial Times reports that Gary Gensler, chair of the Securities and Exchange Commission, supported the introduction of new rules on leveraged exchange traded products.
The statement is the latest in a string of warnings from U.S. regulators going back over a decade, touching upon the risks to individual investors posed by leveraged products.
“I believe that potential rulemaking could strengthen the investor protections around these products. [Leveraged ETPs] can pose risks even to sophisticated investors and can potentially create system-wide risks by operating in unanticipated ways when markets experience volatility or stress conditions,” Gensler said Monday.
Leveraged ETFs utilize derivatives to leverage or multiply daily performances of a benchmark, like the S&P 500. However, leveraged ETFs are meant to be calculated daily, so these bets can compound when investors hold them for more than a single day. While the compounding effect is beneficial when the markets are in the investor’s favor, losses can also be compounded and magnify losses beyond the intended daily 200% or 300% target over time.
Regulators are eyeing the space as investor interest and assets in leveraged ETFs rise. Global assets in leveraged and inverse ETPs was at $112 billion as of the end of August, compared to $80.8 billion at the end of 2017, according to ETFGI data. Inverse ETPs and leveraged inverse ETPs allow investors to capitalize off falling benchmarks.
Allison Herren Lee and Caroline Crenshaw, two of the SEC’s five commissioners, also issued a joint statement supporting Gensler’s bid for stricter rules on leveraged products. They argued for reviving plans to force brokers and investment advisers to enact more detailed checks to ensure clients fully understand the risks before allowing retail investors to buy and sell leveraged products.
“SEC commissioners continue to have concerns that the risks connected to leveraged ETPs are not well understood. They are likely to make it harder for self-directed investors to purchase these products. While these ETPs comprise a small slice of the market, they often attract significant interest from tactical investors,” Todd Rosenbluth, head of ETF and mutual fund research at CFRA, told FT.
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