The US Securities and Exchange Commission poured cold water on the latest crop of ultra-leveraged ETFs by cautioning issuers not to go ahead with the launch of their proposed aggressive funds, which include those offering five times the daily return of a given index.
The SEC's Division of Investment Management held a rare group call on Monday with independent trustees and fund counsel, according to a report by Bloomberg. It was reportedly decided that the issuers, ought not to go effective, which is the final stage of clearance prior to the launch of a fund registration.
Rule 18f-4 Under Spotlight
At the heart of the SEC's concerns is the Rule 18f-4, the SEC's risk management framework for the use of derivatives. It was adopted in 2020 and established restrictions on the amount of leverage permitted for registered funds relative to their assets. The proposed ultra-leveraged products would need to meet the requirements of this Rule. However, regulators are not yet convinced that these next-generation funds can meet the standards of the Rule's safeguards.
The new batch of filings reportedly includes ETFs seeking leverage levels as high as 5x daily exposure — a level up from the more common 2x and 3x structures already in the market.
Retail Demand Meets Regulatory Friction
Leveraged ETFs employ derivatives such as swaps and futures to multiply the daily return of the underlying index or asset. However, the downside of this leverage is that the losses are compounded to the same degree that the gains are compounded. In addition, the daily compounding of the leverage means that the return on the investment can diverge significantly from the multiple implied by the fund's name when the holding period exceeds one day.
What was once considered a niche investment for hedge funds and professional investors, leveraged ETFs have become incredibly popular among the broader retail public. Volatile markets, the proliferation of zero-commission trading, and the influence of social media on trading activity have all contributed to the growth.
Given the apparent demand, ETF issuers have continued to increase the leverage ratio of the funds, first on single stocks, and then on the broader leveraged index funds.
Warnings Cropped Up Last Year
Toward the end of last year, there were fears that the industry is heading toward speculative excess. Leveraged ETFs were becoming increasingly aggressive.
In October last year, the filing by VolatilityShares to launch 5X leveraged ETFs tracking Bitcoin, Ethereum, Tesla Inc (NASDAQ:TSLA), Strategy Inc (NASDAQ:MSTR), and Solana had alarmed even seasoned analysts.
“That filing was mind-blowing,” Morningstar analyst Daniel Sotiroff had told Benzinga. “About half of the leveraged ETFs launched more than three years ago have shut down, and another 17% of them have lost 98% of their value. The 5x leveraged ETFs are just amplifying those risks.”
The SEC's intervention suggests regulators are drawing a line before the industry moves into even more aggressive territory.
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