U.S. regulators just approved the first set of quadruple-leveraged exchange-traded funds. This sounds somewhat terrifying on its face, and indeed the idea of it immediately spurred outrage on social media and elsewhere.
Certainly the idea of someone’s grandmother plowing her money into some ultra-leveraged fund through her E-Trade account sounds like a slam-dunk recipe for disaster. Make no doubt, these ETFs are potentially problematic, but grandma’s not an accurate picture of who will end up using them. That said, it remains important to understand where the risks truly lie.
The point of leveraged ETFs is usually to make it easier for institutional investors to make super-juiced wagers. These investors would most likely be making similarly risky bets using futures or options markets without the new ETFs. The ETF wrapper just makes it easier, perhaps by allowing investors to avoid registering or posting collateral with clearinghouses.
But it’s concerning that hyper-leveraged ETFs are considered stocks, the same as plain-vanilla ETFs. Investors who buy these funds could potentially obscure riskier wagers by making them through ETFs rather than the underlying derivatives themselves.
On Tuesday, the Securities and Exchange Commission approved a request to list the ForceShares Daily 4X U.S. Market Futures Long Fund and ForceShares Daily 4X U.S. Market Futures Short Fund.
The Long Fund’s goal is to generate returns that are about 400 percent of the daily performance of the underlying S&P 500 futures contracts, according to an SEC filing. The Short Fund seeks to generate the exact opposite return.
The audience for this type of fund is pretty small. As is, leveraged ETFs account for just 2 percent of all ETF assets, according to Eric Balchunas, a Bloomberg Intelligence analyst.
Still, these funds oversee a big enough pool of money to consider, especially given the fact that the U.S. ETF market has swelled to nearly $3 trillion. It seems ludicrous that all ETFs are painted with the same brush, regardless of the fund's underlying assets and liquidity. By not distinguishing an exotic fund from a plain-vanilla one, there's a bigger risk that investors will insufficiently account for volatility in their portfolios and in a specific market, especially if the ETF accounts for a more significant proportion of trade in the asset class.
A while back, Balchunas recommended a ratings system for ETFs, similar to the scale used for movies, to help guide uninformed investors away from highly volatile offerings. Under such a system, Balchunas would give these latest four-times leveraged funds an R rating. It seems like a good idea to have a way of distinguishing the riskiest funds from the safer ones. Otherwise, the dangers of these funds could emerge at unfortunate and unexpected times.
This column does not necessarily reflect the opinion of Bloomberg LP and its owners.
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