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SEC Proposes New Rule to Ease the Market Entry of Leveraged ETFs

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The SEC has proposed new a new rule that would make it easier for leveraged and inverse ETFs to come to market. If the rule is approved, those ETFs would no longer be excluded from coverage of the agency’s ETF modernization rule, which allows funds to come to market without first obtaining an exemptive order.

The proposed rule applies to derivatives used by mutual funds, closed end funds and business development companies as well as leveraged and inverse ETFs and sets several conditions for  their use. It replaces a previous rule from 2015 that was never implemented.

SEC Chairman Jay Clayton, in a statement, said the proposed derivatives rule, which is subject to 60 days of public comment after publication in the Federal Register, “would benefit investors, funds and our markets, including by providing for more-effective risk management across funds and enhanced investor protections” by “standardizing the framework for funds’ derivatives risk management.”

In the current regulatory environment, “different funds may treat the same kind of derivative  differently,” based on “their own view of SEC staff guidance and observation of industry practices,” according to the SEC.

There is currently no commission-wide rule restricting funds’ use of derivatives but rather a patchwork of commission interpretations and staff guidance on their use. The new SEC proposal provides a more comprehensive approach towards the use of derivatives by multiple types of investment funds.

It would limit leverage risk to 150% of the fund’s value of risk (VaR) but funds using derivatives for hedging currency risk only or limit derivatives exposure to 10% of net assets would not be subject to the VaR-based leverage risk limit.

Leveraged or inverse ETFs would be exempt from the 150% VaR limit provided they targeted a 300% return or less of the underlying index, or its inverse and disclosed they were not subject to the VaR limit. In addition, the BDs and investment advisers selling those ETFs would need to determine if there was “a reasonable basis to believe” that their clients were “capable of evaluating the risks” associated with the funds. 

All types of funds covered by the new derivatives proposal would generally be required to implement a written derivatives risk program whose manager would have to report to the fund’s board on the program’s implementation and effectiveness. The program would have to include risk guidelines, stress testing, backtesting, interrnal reporting and escalation and review elements.

The Investment Company Institute, the trade group for mutual funds and ETFs, said it was “pleased” with the proposed derivaties rule and “hopeful” that after completing its analysis it would find that the rule “will preserve funds’ ability to continue to use derivatives as an effective portfolio management tool.”

The rule would benefit fund companies like ProShares and Direxion who are leading issuers of leveraged ETFs by creating “a set of uniform rules instead of what is in place,” said Todd Rosenbluth, head of ETF and mutual fund research at CFRA.

It is “enormously sensible” and long overdue, said Dave Nadig, managing director of Referring to the ProShares and Direxion inverse ETFs, he noted the “duopoly that really isn’t in anyone’s interest. Cleaning up and leveling the playing field is a good thing.”

Ben Johnson, director of global ETF and passive strategies research at Morningstar, is not so sure. He said that leveraged and inverse ETFs have no place in most individuals’ portfolios and the new rule creates the “risk that most individual investors won’t understand how these funds work, which creates the risk that they won’t use them well.”

ProShares told ThinkAdvisor it is “in the process of reviewing the SEC’s proposal and its potential consequences for investors, including those who have been using leveraged and inverse funds for over 20 years as valuable tools for managing risk and enhancing returns in their portfolios.” Direxion officials were not available for comment.

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