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Risky Corner of ETF Market Could See More Debuts After SEC Vote

A long-considered rule change in the $4.8 trillion exchange-traded fund industry could make it easier to issue risky products similar to the ones that have blown up during recent bouts of volatility.

The Securities and Exchange Commission will vote Wednesday on a final rule change to ease the approval of leveraged and inverse ETFs — which use derivatives to boost gains. That could eliminate the need for many issuers to seek a special order from the SEC to allow their funds to operate, and instead let them use the same streamlined process available to standard products.

Leveraged funds have a reputation as the “bad boys” of the industry because their strategies can exacerbate losses, especially for less-experienced traders. In a year that’s seen wild market swings and a flurry of retail investors clamoring for products that could amplify their returns, the category has taken in about $9.7 billion, and is track for its biggest annual inflows in more than a decade. Even Robert Whaley, who created the VIX index of stock volatility, has warned about the risks in the market for exchange-traded products that use derivatives.

“Leveraged and inverse funds pose substantial risks to investors, but if the SEC is going to allow them, there should be consistency in the product approval process — which this proposal would help achieve,” said Nate Geraci, president of the ETF Store.

Opening the Gates

The only two issuers that are able to release leveraged products in the U.S. are ProShares and Direxion, with $44.8 billion and $15.5 billion in ETF assets, respectively. But that dominance could change under the SEC proposal, with new issuers flooding the market, according to a report from Bloomberg Intelligence. It’s a development that could point to new risks for inexperienced investors.

Trading volume on those products has doubled this year due to retail traders looking to make volatility bets, BI noted. They now comprise 13% of all ETF trading, but with only around 1% of total assets.

That rush of retail investors has been especially evident in the $9.1 billion ProShares UltraPro QQQ ETF (TQQQ), which seeks investment results that correspond to three times the daily performance of the Nasdaq 100. The fund had its best month of inflows on record in September amid a selloff in technology shares.

Direxion declined to comment on the potential impacts of the SEC proposal, while ProShares wasn’t immediately available for comment.

Dwindling Market

Despite that retail boost, more than 30 leveraged products have already closed this year, including several that got whipsawed during oil’s price volatility.

ProShares liquidated both its UltraPro 3x Crude Oil exchange-traded fund (OILU) and its UltraPro 3x Short Crude Oil ETF (OILD), while Direxion shuttered its Daily Natural Gas Related Bull 3X Shares ETF (GASL).

Some argue that the two issuers have already launched most of the viable leveraged strategies out there, leaving little room for more. Outside of the increased interest from retail investors this year, assets in such funds have been relativity stagnant in the past five years.

“These products have found their natural investment base, people who know them, understand them and can use them well,” Ben Johnson, Morningstar’s global director of ETF research.

Both issuers have been trying to expand their offerings outside of just leveraged products, with Direxion releasing a work-from-home ETF in June to take advantage of the shift to remote working during the coronavirus pandemic.

More than 200 funds have started trading in 2020 so far, about 40 more than at the same time last year, according to data compiled by Bloomberg.

Fine Print

Another aspect of the new rules is that they would entail additional reporting requirements — which may discourage brokerages from offering such products.

Under the proposal, brokerage firms would have to determine if clients understand the funds’ risks and formally approve their requests to buy, which would mean asking for information about the investor’s experience, employment status, annual income and net worth.

Still, the new rules would at least give the option for firms beyond Direxion and ProShares to explore leveraged strategies.

“I would encourage investors to really understand what they are getting when they are purchasing such products, but leveling the playing field for all issuers is certainly in my mind a positive thing,” Jillian DelSignore, principal at Lakefront Advisory.

— With assistance by Benjamin Bain

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