A New SEC Proposal Would Open the Door for More Leveraged ETFs
Written by Jasmin Sethi for SCA client, Morningstar.
A new SEC proposal could lead to a proliferation of an exotic type of exchange-traded fund: the leveraged ETF. Right now, only two fund companies offer these products--ProShares and Direxion--but that could change if the proposed rule is adopted. Fortunately for investors, it would also add safeguards to ensure that investors who purchase them have been evaluated for suitability of the product. These are confusing products with risks that investors do not usually understand, and we think if the SEC permits more of them, investors should demonstrate sufficient familiarity and understanding before making a purchase. We do appreciate the compromise the SEC is making--leveling the playing field by allowing competition in the product space and simultaneously adding safeguards so that retail investors, even in self-directed brokerage accounts, have to jump through some hoops before purchasing these products.
As we warned in 2016 and even earlier in 2009, it is hard to overstate the risks of owning leveraged and inverse exchange-traded funds. These funds are designed for a one-day holding period, a horizon over which price movements are unpredictable. In general, leveraged ETFs amplify those movements. Over holding periods longer than one day, the funds’ performance can diverge sharply from what many investors might expect.
In its recent proposal regarding the use of derivatives in registered funds, the SEC has streamlined the process for launching leveraged and inverse-leveraged ETFs that maintain a leverage level below 300%. The ETFs that limit their market exposure by providing that the fund must not seek or obtain investment results exceeding 300% of the return (or inverse of the return) of the underlying index do not have to go through a rule-filing process with the commission. This change will make these funds far easier to launch and likely more available, though we do not believe that these funds are beneficial to most investors.
