SEC Officials Blast Leveraged ETFs, Other Funds Get Easier Path

(Bloomberg) -- Two top officials at the Securities and Exchange Commission are sounding the alarm over leveraged exchange-traded funds -- even as the agency looks to streamline sales of simpler ETFs.

Robert Jackson Jr., who holds a Democratic seat on the SEC, criticized a failure to address these “dangerous” funds in a proposed rule that would make it easier to bring plain-vanilla ETFs to market. Meanwhile, Kara Stein, a Democrat, posed a series of questions about who these products are appropriate for, and what their impact is on underlying markets. The regulatory body’s five commissioners voted unanimously to advance the planned rule to public comment.

Leveraged ETFs “pose real risks to American families,” Jackson said. “I’m worried that many investors are going to find out -- too late -- exactly how dangerous those products can sometimes be.”

The funds in question are called “leveraged” because they hold derivatives that deliver a juiced-up form of their strategy to improve the performance of their portfolio. For example, the popular ProShares Ultra S&P500 ETF, ticker SSO, uses these securities with the goal of providing twice the daily performance of the S&P 500 Index. Roughly 1 percent of the $3.5 trillion of assets in exchange-traded products is invested in leveraged vehicles, according to data compiled by Bloomberg.

Appropriate Investment

SEC Chairman Jay Clayton, a political independent who was named by President Donald Trump, said after the meeting that he was talking with Jackson about the issue. He indicated that the products could possibly be addressed as part of sweeping new conduct rules the agency has proposed for brokers and investment advisers. Any new regulation regarding the funds would require Clayton’s support.

“Leveraged ETFs and similar complex products are ones that you need to go through a lot of work to ensure that that type of product is appropriate for your customer,” he said.

This isn’t the first time a commissioner has singled out leveraged ETFs for criticism. Stein noted in February that the regulator “continues to see abuses” related to the purchase and sale of complex products such as leveraged funds, weeks after an exchange-traded note blew up, destroying the investments of retail and institutional owners alike.

That debacle highlighted the difference between ETFs and other exchange-traded products, which don’t require the SEC’s nod before they start absorbing investor cash. But both ETNs and products that are structured as commodity pools are subject to the agency’s disclosure regime and trading rules, giving the SEC some ability to police them.

‘ETFs On Steroids’

For instance, a duo of four-times leveraged products that would have given investors a high-octane bet on the S&P 500 seemed to get the green light last year, only for the SEC to stay an order that would have allowed them to list. Those products have yet to start trading.

“We need to avoid thinking about exchange-traded products as a monolith,” Stein said Thursday, after describing leveraged funds as “ETFs on steroids.” “Are leveraged and inverse ETFs appropriate for all investors? If not, for whom are they appropriate and under what circumstances?” she asked, adding “we still need to address these questions.”

Only two companies currently sell such funds in the U.S., under the ProShares and Direxion brands. Several more sell leveraged ETNs.

A derivatives rule that the SEC put forward back in 2015 could have restricted the amount of leverage used by funds, including ETFs, but that proposal hasn’t been finalized.

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