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New rules covering the use of derivatives by investment managers have triggered sharp disagreements among top US regulators after the Securities and Exchange Commission unexpectedly abandoned proposals for controls on the sale of leveraged exchange traded funds to retail investors.
The SEC said it would review the effectiveness of its existing investor protection rules but declined to impose any new controls on sales of leveraged and inverse ETFs in a ruling on Wednesday that provided a green light for new competitors to enter the market.
“Consumer protection advocates will argue that the SEC has ‘put the cart before the horse’ by allowing more leveraged ETFs to be launched without first ensuring that the appropriate protections for retail investors are in place,” said an analyst that declined to be named.
US regulators have previously issued repeated warnings that leveraged and inverse ETFs are not suitable products for retail investors because these funds, which use derivatives to multiply returns, can generate unexpectedly large losses.
The SEC proposed last year that retail investors should only be allowed to buy and sell leveraged ETFs if their broker or investment adviser had first carried out checks to ensure that their clients properly understood the risks.
But the proposed sale restrictions sparked an outcry from investors who sent more than 6,000 comment letters to the SEC, all but 70 of which addressed the proposed sale restrictions.
Allison Herren Lee, one of the SEC’s five politically appointed commissioners, said that she was “deeply disappointed” by the regulator’s failure to address the “very real investor harms” that arise from unsuitable sales of leveraged and inverse ETFs.
“Retail investors, and even investment professionals, often do not understand the risks involved in holding leveraged and inverse ETFs for periods exceeding the fund’s relevant time horizon, which is typically one day,” said Ms Lee.
A second commissioner, Caroline Crenshaw, also criticised the decision and pointed out that the SEC was aware of many instances of significant losses incurred as a result of retail investors buying leveraged and inverse ETFs.
Leveraged and inverse ETFs are designed as short-term trading instruments and investors that hold them for more than a single day can experience negative returns even when the underlying index has positive returns.
But about a quarter of the investors in some popular leveraged ETFs held on to these positions for more than a month while 8 per cent owned their holdings for three months, according to a study in 2010 by Securities Litigation and Consulting Group, a Virginia-based consultancy.
Concerns over risky usage of the products prompted the SEC to tighten its rules in 2012, in effect preventing new participants from entering the market and restricting the issuance of leveraged and inverse ETFs to a small handful of specialised providers.
But Wednesday’s announcement means those restrictions have now been dropped just as leveraged and inverse ETFs are seeing a big increase in new business.
Investors ploughed $12.2bn into leveraged and inverse ETFs (funds and products) in the first nine months of 2020, compared with net inflows of just $32m over the whole of last year, according to ETFGI, a consultancy.
Volatile market conditions have led to the abrupt closure of at least 38 leveraged and inverse exchange traded products so far this year. Investors who do not sell out of their holdings before the delisting date can be left with positions that are difficult and costly to liquidate.
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