The Securities and Exchange Commission approved a controversial new rule today that will essentially allow ETFs’ to double their use of leverage and derivatives, while punting on sales practices constraints that had originally been proposed.
Leveraged and inverse ETFS have helped investors capitalize on wild market swings, with the category attracting $9.7 billion and on pace for its biggest annual inflows, but not without significant risks and sometimes losses to investors.
While the new rule creates an outer bounds limit on ETFs’ use of derivatives and leverage and eases the approval of such ETFs, the commission removed new sales practices regulation from the proposal that would have created higher standards of care and disclosure for reps and advisors who sell geared funds, or exchange-traded funds (ETFs) and mutual funds that track a variety of benchmarks, from stock market indexes like the S&P 500 to the price of a commodity like gold.
As a result of the removal of tougher sales practices, commissioners Allison Herren Lee and Caroline Crenshaw declined to support the proposal.
“Evidence suggests that retail investors buy these products without understanding risk and or objectives,” Crenshaw said. “Just this morning, [SEC] Chairman [Jay] Clayton issued a statement that said Reg Best Interest will do nothing to protect these investors who buy these products through self-directed brokerage accounts."
SEC staff denied the new leveraged ETF rules will increase retail investor risks. The SEC is asking for public comment regarding how risky products in general should be regulated.
“Looking across the landscape of registered funds, are there any areas that materially increase or decrease fund’s risks?” Clayton asked at today’s meeting.
“The new framework will not increase risks in any material way,” replied Dalia Blass, director of the SEC's Division of Investment Management. “Our recommendation will actually constrain funds that are taking on significant leverage risk while allowing funds that use derivatives in a prudent way to continue to do so while managing their related risks.”
Lee disagreed. “These are products that often confuse financial professionals. I supported this rule at proposal stage ... but the commission doubled the risk limit for all funds. This means that even those funds with a benchmark that is an appropriate yardstick are allowed to take on twice the risk the commission proposed at the outset.”
Equally troubling, Lee said, is that “important disclosures were removed because it may confuse investors, so best they not have access to it. These confused investors are, however, the same ones for whom we now decline to approve sales practice rules.”
Most disappointing is the SEC’s failure to advance proposed sales practice rules that were designed to address the investor harm rising from sales of leverage and inverse ETFs, Lee said. Enforcement cases from the SEC and Finra show that even investment professionals often lack a basic understanding of these complex products, Lee added.
Suggesting that the proposed sales practice rules are “underinclusive is no excuse,” Lee added. “Indeed, other types of complex products not addressed by rule may cause similar harm to unsophisticated retail investors," Lee said. "But that does not justify why we fail to act now to protect retail investors in inverse and leveraged ETFs.”
Instead of approving sales practices for leverage or inverse ETFs, Clayton and senior staff published a joint statement today that asks for comment on what sales practices for complex products overall should like. The statement is available here.