FINRA Fires Next Shot in War Against Leveraged ETFs

Dow Jones is reporting that investors in exchange traded funds (ETFs) that use leverage to achieve 2x and 3x of certain indices and inverse ETFs, funds that attempt to perform -1x certain index, are going to face higher margin requirements in the months to come.

In an article published yesterday, Ian Salisbury of Dow Jones explains that the Financial Industry Regulatory Authority (FINRA) believes that investors are combining buying inverse ETFs on margin, which compounds the effects of leverage. Brokers and their clients have used inverse and leveraged ETFs as an alternative to margin accounts needed to buy stocks on leverage or options to achieve similar strategies. It seems FINRA believes that investors are actually buying leveraged ETFs on margin — a no-no from a regulatory standpoint.

A FINRA spokesperson stated:

“They are buying a leveraged ETF, then taking on additional leverage through a margin account,” he says. “We felt it needed to be addressed.”

Tom Lydon, the axe and expert on everything ETF, explains the new margin requirements for investing in these types of securities:

The requirements will be increased “by a factor commensurate with their leverage.” The current requirement for a long ETF is 25% of the ETF’s market value; the new requirement would be 50%. In a triple leveraged ETF, the requirement would be 75%. In a short ETF, the margin requirement is 30% of the ETF’s value; it would double to 60% under the new rules.

The requirements won’t exceed 100% of the ETF’s market value.

Is this a big deal? Well, yeah. FINRA and the SEC are certainly on the prowl for inverse and leveraged ETF blood. Investors and brokers who serve them have used these types of ETFs in accounts to take directional bets. Option trading allows these types of bets as well. I think the main difference is that investors need to be approved for options trading and explained the risks inherent in using leverage. ETFs trade like stocks and I’ve seen people who would never short stocks in their lives, use inverse ETFs and not think twice.

Again, I don’t think there is anything inherently wrong in the security itself. These ETFs are really easy and relatively cheap ways to take directional bets and hedge portfolios. The problem resides in investor understanding of these products, their pros and cons, and how they can help or hurt a portfolio. FINRA is using regulatory muscle to try and make this happen.

You can check out below what Tom had to say recently about inverse and leveraged ETFs on CNBC.

Comments

[Scared Stiff:]

"I’ve seen people who would never short stocks in their lives, use inverse ETFs and not think twice."

Well of course!! With an inverse ETF, you will never lose more than your principal. That makes them inherently safer vehicles than shorting.

Sep 02 10:57 AM

[Mick Weinstein:]

Is there any evidence that this will solve any significant systemic problem?

Sep 02 11:50 AM

[GoochyPuppy:]

@Scared: Thank-YOU for making that point.

Anyone who actually sells short a stock (as opposed to buying an inverse ETF), and does not hedge it, faces infinite losses (unlimited ... we're talking lose your home here...). Shorting is much much less safe than an inverse ETF.

Sep 02 01:47 PM

[Alan Young:]

I find inverse ETFs easier to use than single-stock shorts. A sector or index is less volatile (usually) than a single stock, so it's easier to track a trend and know when to cover (or in this case, sell).

But now more and more stocks, even highly-liquid ones like FSLR, are showing up as "hard to borrow." So there isn't even a choice.

Sep 02 02:00 PM

[bcncv:]

Ignoring all of the other controversy about leveraged ETF's, this deals with a relatively narrow aspect of the product.

The question is, should margin differ if you borrow to purchase an underlying index versus a leveraged product?

The answer is clearly yes. The margin requirement should take into consideration the volatility of the underlying asset. It does seem like some of the new requirements are a bit high, but on principle, they should be differentiated.

Sep 02 02:53 PM

[whidbey:]

Wonderful to have such oversight. We know the etfs were and are likely to wreck the economy like the banks did, NOT. This is another instance of the nanny state slamming the door shut on ants. What utter dismal ignorance will we be asked swallow next?

Sep 02 03:49 PM

[GoMyLittleS...:]

"Well of course!! With an inverse ETF, you will never lose more than your principal. That makes them inherently safer vehicles than shorting. "

Oh yes, so much safer, right. Too bad you and the other don't seem to understand that mathematically all daily inverse ETFs must drift to zero - even if the ETF stays flat.

Let's say you got lucky and bought the inverse S&P etf at the exact top of the S&P in mid-2007. Without looking, tell me what your return would be on the ETF? Give up? 2% return amidst the largest decline in recent history. Meanwhile the "risky" short has gotten himself a good 35% profit. Don't ask how bad the leveraged ETFs are doing.

But yes, it's much less riskier, I agree: with shorts you MIGHT lose your money and more - with inverse ETFs you're GUARANTEED to lose you rmoney so no uncertainty there.

I guess these ETFs truly accomplished their goal of pulling in gullible investors into the myth they're "easy and safe".

Sep 02 04:47 PM

[Scared Stiff:]

Ha ha, I never claimed the inverse ETFs are a good investment. A good play in the very short term, yes, but not a good investment. Even so, you will never lose more than what you put up.

Sep 02 07:27 PM

[Vardan Balyan:]

Can FAS or FAZ completly get wiped in a day if there is a big enaugh move in financials ?

Sep 03 01:11 PM

[Rhee Ali Tee:]

It's time for a class action lawsuit. Who does Tom Lydon and FINRA think such investors are? We are everyday individual small time investors. Now that we have a chance to play on the same field as Goldman or JPM, that is suddenly not allowed? This is America not China where investors cannot make more than 10%...

Sep 03 06:52 PM

[Daniel J. Voth:]

For traders like myself who now how to take advantage of 2x & 3x ETF's this will significantly impact my returns into 2010 and beyond. I'm not at all happy about the new margin limits. Let's just hope that this is the end of FINRA messing around with these reliable decaying products. LONG LIVE THE DECAY TRADE!!!

Sep 04 01:48 AM

[GreenMom:]

Can someone explain whether an inverse, leveraged ETF like FAZ can actually AFFECT its sector, or does it just do a benign 3x inverse tracking? Is the way that the 3x inverse is done detrimental to the sector if done in enough volume?

Reason that I'm asking -- we all heard Jim Cramer ranting and raving about the SKF -- "the ETF of mass destruction." How would an ETF be a destroyer? Just curious if this is another reason that these things are getting so much heat lately.

Many thanks in advance for insights.

Sep 08 02:50 PM

[GreenMom:]

No. In the case of FAS, all components of the Russell 1000 Financial Index would have to go to zero. In the case of FAZ, all would have to go to infinity.

Which did you buy and at what price point?


On Sep 03 01:11 PM Vardan Balyan wrote:

> Can FAS or FAZ completly get wiped in a day if there is a big enaugh
> move in financials ?

Sep 08 03:01 PM