Given the heightened volatility in the stock markets, leveraged ETFs have gained immense popularity as investors are making a dash for big gains on quick market turns. This is because these funds try to magnify returns of the underlying index with a leverage factor of two or three times on a daily basis by creating either a long or short position (often called inverse leveraged) through the use of swaps, options, future contracts and other financial instruments.
Due to their compounding effect, investors can enjoy higher returns in a very short period of time, provided the trend remains a friend. However, the attraction might fade in the coming months given that the SEC is in the process of implementing some measures that would restrict the amount of funds that can be invested in these products.
Proposed New Rules
The SEC proposed to limit the leveraged factor created by a fund's use of derivatives to 150%, or 1.5 times of net assets. Additionally, according to the rules proposed last December, the fund should manage the risks associated with derivatives by segregating certain assets (generally cash and cash equivalents) equal to the sum of two amounts:
- 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.
- 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 it would pay if the fund exited the derivatives transaction under stressed conditions.
These rules, if enacted, would shake the leveraged ETF world, and 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 (see all Leveraged Equity ETFs here).
As per xtf.com, there are currently 136 leveraged products and 87 leveraged inverse products. Of these, 46 leveraged and 36 leveraged inverse products have three times exposure to the underlying index and would be the most in trouble. Investors should note that the SEC-proposed rules would impact the leveraged long and short ETF space that are 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 have been structured via the Investment Company Act of 1940.
Some of the most popular triple leveraged plays are the Direxion Daily Financial Bull 3x Shares ETF (NYSEARCA:FAS), the Direxion Daily Gold Miners Index Bull 3x Shares ETF (NYSEARCA:NUGT), the ProShares UltraPro QQQ ETF (NASDAQ:TQQQ), the ProShares UltraPro S&P 500 ETF (NYSEARCA:UPRO), the Direxion Daily Small Cap Bull 3x Shares ETF (NYSEARCA:TNA), the Direxion Daily S&P Biotech Bear 3x Shares ETF (NYSEARCA:LABD), the Direxion Daily Energy Bear 3x Shares ETF (NYSEARCA:ERY), the Direxion Daily Emerging Markets Bear 3X Shares ETF (NYSEARCA:EDZ), and the ProShares UltraPro Short Russell 2000 ETF (NYSEARCA:SRTY).
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).
The SEC is expected to make a final decision on the proposed rule in the third quarter of this year. Even if the rules are adopted, it will take months or a year to have a full impact on the leveraged ETF world.