- Regulator's proposal would cap fund leverage at 150% of assets
- Chair White says she's concerned current rules now outdated
U.S. regulators have declared war on the $32 billion leveraged ETF industry.
A proposal issued Friday by the Securities and Exchange Commission could handicap a product that has drawn warnings from BlackRock Inc.’s Laurence Fink and Wall Street’s brokerage regulator, the Financial Industry Regulatory Authority. Built like mutual funds, leveraged exchange traded funds managed by companies such as ProShare Advisors LLC and Direxion use derivatives that produce daily gains or losses that can be three times greater than an index they track, such as the Standard & Poor’s 500 Index.
If eventually approved as a final rule, the SEC’s plan might render some of those strategies unworkable by capping the leverage such funds can derive from derivatives at 150 percent of their net assets. It would also force them to hold a lot more cash to cover potential losses. The proposal represents one of the most aggressive responses yet for regulators who have ramped up scrutiny of asset managers in the wake of the 2008 financial crisis.
“It looks like this could regulate anything that offers leverage greater than 1.5 times assets out of existence,” said Ben Johnson, global director of ETF research at Morningstar Inc.
While most mutual funds don’t use derivatives at all, about 4 percent of funds have exposure that exceeds 150 percent of net assets, according to an SEC study issued Friday. Some of those highly-leveraged funds could choose to deregister as mutual funds instead of paring back their use of derivatives or building larger cash buffers, SEC Chief Economist Mark Flannery said Friday at a meeting where SEC commissioners approved the measure on a 3 to 1 vote. Such funds could choose to become private funds instead, which would limit their investor base to institutions and wealthy clients.
Net flows into leveraged ETFs have grown in recent years even as regulators and executives like Fink have warned they might not be safe for retail buyers. Fink said in May 2014 that leveraged ETFs have the potential to “blow up” the industry and that he couldn’t understand why the SEC approved their sale in the first place. BlackRock owns the iShares family of exchange-traded products.
Finra, which polices the sales practices of brokers, also came down on ETFs in June 2009, when it said they “typically are unsuitable for retail investors who plan to hold them for longer than one trading session.” More sophisticated investors such as hedge funds are inclined to get in and out of leveraged ETFs quickly before potential losses can build up.
The SEC plan might not spell doom for all levered ETFs, as the regulator’s proposal says some funds that seek to “deliver two times the performance of an index may be able to achieve this level in compliance” with the rule. The SEC also asked for comments on whether it should grandfather funds that currently exceed the 150 percent limit. Many ProShares funds seek to double their exposures to the indexes they track.
SEC Chair Mary Jo White said Friday that she was concerned the SEC’s rules are outdated for an era when some funds’ derivatives exposure can exceed ten times the value of their net assets.
“The current regulatory framework no longer effectively achieves the statutory objectives of the Investment Company Act, which seeks to protect investors from the risks of excessive leverage,” White said.
Many managed futures funds also rely heavily on derivatives for their strategies, which typically use computer algorithms to track trends in asset prices. These funds may find it difficult to adhere to the 150 percent cap, the SEC said in its proposal, because derivatives are central to the bets they make on things like currencies, interest rates and commodities.
Republican Commissioner Michael Piwowar cast the lone vote of the four-member SEC against the proposal. He said there was no justification for the new leverage restriction because the SEC already imposes collateral requirements that limit a fund’s derivatives holdings.
Several leveraged ETFs managed by ProShare Advisors LLC held derivatives whose value exceeded 150 percent of net assets as of the end of May, according to the fund company’s most recent annual report. Seven of the ten largest leveraged ETFs by assets are sponsored by ProShares, which also offers ETFs whose returns mimic short selling by seeking returns that move in the opposite direction of a stock or bond index.
The largest leveraged ETF, the $2.6 billion ProShares UltraShort 20+ Year Treasury, uses swaps and futures to produce daily returns that are two times the inverse of the Barclays U.S. 20+ Year Treasury Bond Index. It held swaps contracts worth 198 percent of net assets as of the end of May, according to the fund’s annual report. The fund has declined 12 percent over the past year, according to data compiled by Bloomberg.
ProShares said through a spokesman that it would review the SEC’s proposal and noted it’s uncertain what a final version of the regulation will look like. The SEC’s plan was issued for public comment Friday for 90 days.
“Ultimately, we believe we will be able to continue to offer leveraged and inverse mutual funds and ETFs to help investors manage risk and enhance returns,” the company said.
Jaime Doyle, a spokesman for Direxion, said the firm “is currently reviewing the entire proposed rule addressing regulation of derivative use by funds to fully understand its impact.”
Leveraged ETFs also could suffer under the proposal because it would force them to carry enough cash or cash-like investments to cover losses that would be realized under stressed market conditions. Under the SEC’s current guidance, funds have been allowed to pledge any type of liquid security to cover just the daily gain or loss for many types of derivatives contracts.
“If they are no longer able to rely on any liquid asset and must use cash or cash equivalents, funds that use a lot of derivatives may be unable to operate,” said Brendan Fox, a partner at Dechert LLP and a former SEC attorney.