Proposed SEC Rules Could Shake Leveraged ETFs

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Includes: FAS, SPXU-OLD, SQQQ, TMV, TNA, TQQQ, TZA, UPRO
by: Zacks Funds

Leveraged ETFs have been investors' darlings this year, thanks to stock market volatility. This is because these funds try to magnify returns of the underlying index with the leverage factor of 2x or 3x on a daily basis by employing various investment strategies such as swaps, futures contracts and other derivative instruments.

Due to the compounding effect, investors can enjoy higher returns in a very short period of time provided the trend remains a friend. However, these funds are extremely volatile and are suitable only for traders and those with high risk tolerance. These run the risk of huge losses compared to traditional funds in fluctuating or seesawing markets. Further, their performances could vary significantly from the actual performance of their underlying index over a longer period when compared to a shorter period (such as weeks or months).

Despite this drawback, investors have been jumping into these products for quick turns. Will these allure continue in the months ahead if the new rules proposed by the SEC are enacted?

Inside the New Proposed Rules

Under the proposed rules, the fund has to limit its notional exposure to derivatives of up to 150% of the net assets or 300% if the fund actually offers lower market risk. Additionally, it should manage the risks associated with derivatives by segregating certain assets (generally cash and cash equivalents) equal to the sum of two amounts:

  1. Mark-to-Market Coverage Amount: A fund would be required to segregate assets equal to the amount that the fund would pay if the fund exited the derivatives transaction at the time of determination.
  2. Risk-Based Coverage Amount: A fund would also be required to segregate an additional risk-based coverage amount representing a reasonable estimate of the potential amount the fund would pay if the fund exited the derivatives transaction under stressed conditions.

Apart from these, the fund would implement a formalized derivatives risk management program administered by a risk manager.

ETF Impact

These rules, if enacted, would shake the leveraged ETF world, in particular the triple leveraged funds. This is because the funds might be forced to increase exposure to low-risk and low-return safe assets like cash and equivalents in order to offset the risk of derivatives exposure. This could eat away the outsized returns that the leveraged ETFs have been providing to investors.

Notably, there are 135 leveraged products and 87 leveraged inverse products as per xtf.com. Of these, 46 leveraged and 36 leveraged inverse products have three times exposure to the underlying index and would be the most in trouble. In particular, the proposed rules would hurt the leveraged long and short ETFs structured via the Investment Company Act of 1940, potentially forcing providers to change the legal structure or leverage factor, or to close them.

Notably, Direxion and ProShares are the two issuers that would be the most impacted as they have several equity and fixed income ETFs that rely on three times derivatives-based leverage and has been structured via the Investment Company Act of 1940.

Some of the most popular ones are the ProShares UltraPro QQQ ETF (NASDAQ:TQQQ), the Direxion Daily Financial Bull 3x Shares ETF (NYSEARCA:FAS), the ProShares UltraPro S&P 500 ETF (NYSEARCA:UPRO), the Direxion Daily Small Cap Bull 3x Shares ETF (NYSEARCA:TNA), the Direxion Daily 20+ Year Treasury Bear 3x Shares ETF (NYSEARCA:TMV), the ProShares UltraPro Short S&P 500 ETF (NYSEARCA:SPXU-OLD), the Direxion Daily Small Cap Bear 3x Shares ETF (NYSEARCA:TZA) and the ProShares UltraPro Short QQQ ETF (NASDAQ:SQQQ).

However, some commodity-leveraged ETFs providing investors' triple exposure to the index could escape the new rules by virtue of their registration as commodity pools with the Commodity Futures Trading Commission (CFTC).

In Conclusion

While the SEC proposal is a concern for leveraged ETF providers, it is not yet finalized or may fall apart. Even if the rules are adopted, it will take months or a year to have a full impact on the ETF world.

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