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FINRA taking further aim at inverse and 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. strongman

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’s 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.