The SEC has amended the rules for mutual funds and ETFs using derivatives. The new rules will allow more leveraged and inverse ETFs. What are leveraged and inverse ETFs and how risky are they?
SEC ruling on inverse and leveraged ETFs
In November 2019, the SEC proposed that investment advisors and broker-dealers need to vet individual investors before allowing them to invest in inverse and leveraged ETFs. In the release, the SEC has said, “The Commission has directed the staff to review the effectiveness of existing regulatory requirements in protecting investors, particularly those with self-directed accounts, who invest in complex investment products (including leveraged or inverse products).” The SEC wants more time to review the regulations.
SEC derivative rules
Calling the existing set of rules about derivates “inconsistent and outdated,” the SEC is amending the rules. “The new comprehensive limits on risk will prohibit derivatives use that is inconsistent with the leverage limits imposed by the Investment Company Act, but will allow virtually all funds to continue to serve their investors using the most efficient instruments,” said Jay Clayton, the SEC chairman.
Currently, the inverse and leveraged ETF market is very small and accounts for only about $33 billion in the over $19 trillion mutual fund market excluding money market funds. With the new rules, the SEC has opened the doors for more funds to get into the inverse ETF and leveraged ETF space.
What are inverse ETFs?
An inverse ETF, also known as a short ETF, takes a short position on the underlying index. These ETFs rise in value when the underlying index falls. For instance, the ProShares Short QQQ ETF takes a 1x inverse position on the Nasdaq 100 Index.
Leveraged ETFs can give outsized returns and losses
A leveraged ETF uses debt and derivatives to take a leveraged bet on the index. These ETFs take up to 3x leverage. Your investment would increase 3x the movement in the underlying index. At the same time, your investment would fall 3x the value in the underlying index. The ProShares UltraPro S&P 500 is a 3x leveraged ETF on the S&P 500 Index. Similarly, your returns and losses would be magnified based on the extent of leverage that the ETF is taking.
Leveraged VIX ETFs
There are also leveraged ETFs on the volatility index. The ProShares Ultra VIX Short-Term Futures ETF (UVXY) takes a 1.5x leveraged position on the S&P 500 VIX Short-Term Futures Index. UVXY has gained this week amid the rise in volatility.
Are ETFs safe?
An ETF is as safe or risky as the underlying index. However, if you go for a leveraged ETF, the risk is also amplified along with the returns. Inverse ETFs are riskier compared to other ETFs. Unlike other ETFs, inverse ETFs shouldn't be part of your core portfolio. Instead, inverse ETFs should be used as a tactical allocation if you expect the markets to fall.