A Regulatory Crackdown on Certain Risky Funds Leaves Gaps

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A new Securities and Exchange Commission rule sets limits on leverage. Above, the SEC’s headquarters in Washington, D.C.

Zach Gibson/Bloomberg

One thing that the existence of leveraged funds proves is that if investors want something, chances are the financial-services industry will find a way to provide it, even if it means bending the rules.

For over a decade, funds have been able to do an end-run around leverage restrictions by employing swaps and other derivatives—financial contracts that can amplify an investor’s exposure to benchmarks such as the S&P 500 index, with little money down. But regulators have finally caught up with the industry with a new rule it passed in October.

When Congress created the modern fund industry with the Investment Company Act of 1940, it wasn’t envisioning swaps, which didn’t exist until 1981. In the wake of major blowups of highly leveraged closed-end funds in the 1929 crash, the new law restricted a fund’s borrowing to 50% of assets, meaning you might get a maximum of 1.5 times the upside or downside of a portfolio. In practice, mutual funds hardly used leverage at all, due also to restrictions on the kinds of borrowing permitted, primarily from banks.

Yet with derivatives, today’s exchange-traded funds, which also didn’t exist in 1940, have as much as three times leverage. The largest, the $9.6 billion ProShares UltraPro QQQ ETF (ticker: TQQQ) triples the daily performance of the tech-stock-laden Nasdaq 100 index, and is up an eye-popping 101% in 2020. Meanwhile, the Direxion Daily Semiconductor Bear 3X (SOXS), which provides three times the inverse of the daily return of the PHLX Semiconductor index, is down 92%.

The SEC’s new rule “18f-4” establishes clear derivatives-exposure parameters. It allows the creation of new funds that have two times, or 2X, their underlying benchmark’s exposure via derivatives, but forbids any new funds with three times, or 3X, exposure. It grandfathers in existing 3X funds so they can continue to operate.

The rule was some 10 years in the making. In 2010, after the financial crisis, the SEC issued a moratorium on granting approval to money managers wishing to launch such leveraged funds, pending further review. Like now, it grandfathered in ProShares and Direxion.

The rule opens the door for competition in the 2X ETF space while closing it in 3X. “We’ve had this de facto duopoly for a very long time,” says Rob Nestor, president of Rafferty Asset Management, Direxion’s investment advisor. “Frankly, we’ve never been comfortable with that, because we believe open markets are the bedrock of our financial-products industry.” He feels the moratorium on new 3X ETFs is unnecessary, as “there’s ample evidence that, despite the anecdotes that are often foisted, the vast majority of the marketplace understands the risk.”

One potential benefit to investors from new entrants in the leveraged ETF space would be fee competition. The largest 2X ETF, the $3.8 billion ProShares Ultra QQQ (QLD), also pegged to the Nasdaq 100, has a 0.95% expense ratio, almost five times the unlevered Nasdaq ETF Invesco QQQ’s (QQQ) 0.20%.

Largest Leveraged ETFs

Data through December 21; five- and 10-year returns are annualized.

Source: Morningstar Direct

Yet significant competition seems unlikely. “The larger established players within the ETF industry that likely have a chance to compete do not want to touch these products,” says Todd Rosenbluth, CFRA’s head of ETF and mutual fund research. “They have made it quite clear that leverage and inverse products are something different to them, and are concerned about these products being available in the marketplace.” Rosenbluth is referring to a letter the largest ETF managers, including BlackRock, Vanguard, and State Street, sent to stock exchanges in May requesting that exchanges cease calling leveraged funds ETFs, and reclassify them as exchange-traded instruments. Vanguard won’t even allow these ETFs to be traded on its brokerage.

Moreover, because most investors who buy leveraged ETFs are traders with no intention of holding them long term, asset-management fees are less important than trading volumes. As such, the largest widely traded ProShares and Direxion ETFs will have a distinct advantage over any newcomers.

That said, traditional money managers are no strangers to these tools. Derivatives and leverage are widely used, most notably in bond and alternative, or hedged, mutual funds. Many of the largest actively managed bond funds make extensive use of derivatives, and will sometimes leverage their bets on interest rates, currencies, Treasury bonds, or other fixed-income securities. Although their exposure is applied to less-volatile securities than tech stocks, any kind of leverage can cause problems during periods of market stress.

While the rule will affect all funds with derivative exposure, one glaring omission from it is leveraged exchange-traded notes. Because such investments technically aren’t funds but bank-issued debt instruments—which adds a layer of default risk to the leverage—they aren’t governed by the Investment Company Act. For this reason, ETNs such as MicroSectors Gold Miners 3X Leveraged (GDXU) could launch this December, despite the SEC ruling.

Nestor expects the SEC will probably close this regulatory gap soon. In the meantime, the omission could have unintended consequences.

“I think if you’re going to continue to see net new exposure in the 3X vein, it’s going to just simply go to ETNs,” says Morningstar’s director of global ETF research, Ben Johnson. “This is the way markets respond to new rules and barriers. It’s no different than water. Water finds a way in.”

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