• Charles Heighton

The SEC has backed away from limiting leveraged ETF’s, is this good or bad for retail investors?

By Charles Heighton – The London Financial Markets Editor and VP of Trading at King’s Global Markets

On Wednesday the 28th of October the US Securities and Exchange Commission made the striking choice to abandon any attempts to limit or control the sale of leveraged or inverse exchange-traded funds to normal unsophisticated investors.

The lack of new measures was met with surprise as some groups have been increasingly vocal regarding the danger of these derivatives. Even regulators have been outspoken against these funds because they can quickly go to zero.

New funds will now enter the market offering more of these riskier derivatives, despite the fact that 38 comparable ETFs have closed this year due to volatility.

Leveraged products work by taking additional exposure for every dollar invested, so in a 3x leveraged fund when you invest $1 the fund uses derivates to be 3x exposed. Due to the complexities of the leverage process, these funds have to rebalance each day to ensure that the leverage stays in the desired range. If this rebalancing did not occur daily, then the fund's leverage ratio would change. A by-product of this is that daily gains and losses are locked in. So, these funds can end up negative even when the underlying asset is still positive over the same holding period. This also means that the asset base of the fund can reduce quickly therefore making it harder to achieve actual returns. The below table from Investopedia shows what can happen to a 2x fund, despite the asset being flat by Friday, the ETF is down.

Source: https://www.investopedia.com/articles/exchangetradedfunds/07/leveraged-etf.asp

These funds often have higher fees than other ETF’s which further eats into any return. Trading in and out of these complex ETF’s also normally results in fees beyond the usual. All these elements mean that it is difficult for retail investors to make money off of these funds, but it is very easy to lose your whole investment.

This does not mean they do not have their place. I actually used several levered ETF’s earlier in the year and would have made a significant amount of money on the position, if my platform of choice had not levied such large charges to buy and sell. I was attracted to these products because I wanted to maximise my return on a small amount of capital. This plan worked before fees.

As a UK investor with albeit limited experience with these derivatives, I do think that the SEC should limit them in some ways. Investors should be fully aware of the risks before placing any money in these funds. These funds may even deserve some kind of age or test requirement as they lean more on the side of gambling than investing. If you use them correctly, then you would not hold your position for much longer than a day. Statistics show that a lot of investors hold for much longer.

Yes, levered ETFs are dangerous but retail investors should be trusted with them if regulators are by their side to ensure that they understand the risks and purpose of these derivatives. Without this aid, retail investors should be prudent and ensure that they completely understand how a product works before investing.

Reference List:

[1] https://www.ft.com/content/f607fc5d-8b10-4c09-9274-d040e617caa6

[2] https://www.investopedia.com/terms/i/inverse-etf.asp

[3] https://www.investopedia.com/articles/exchangetradedfunds/07/leveraged-etf.asp

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