December 27, 2015
ETFs, for the first time in history, created opportunity for retail investors that has, in many ways, leveled the playing field between them and large institutions. Individual investors, with a simple purchase, like a stock, can hedge their portfolios to reduce market risk, benefit from opportunities in investment classes such as commodities or sectors, and otherwise choose a lower-cost alternative to traditional funds.
Leveraged funds permit an investor to allocate, and thereby risk, a smaller portion of their portfolio. By investing 5% of a portfolio to 3x ETFs, for example, an investor can allocate the other 95%, instead of 85%, towards other investments, creating a diverse approach to help weather the cycles in the market.
Now, the SEC, claiming to be protecting the consumer, threatens to remove this new tool from the retail investor. As they exist today, many leveraged 2x and 3x ETFs will not be able to operate under the new rules if they are passed when the SEC votes in March.
To be sure, on the surface, the SEC goal looks noble. By the wording of the proposal, it appears that it is trying to ensure that redemptions are protected in the unusual event their is a rapid withdrawal. The only problem isn't what the SEC is claiming to be trying to achieve, but how.
It has chosen an to use a big net in a near admission that it does not understand the complexity of the derivatives markets. The center of its proposal relies on cash accounting and current market value, instead of understanding the ability to build time-based safety into funds using the very tools the SEC is proposing to limit.
For instance, funds using near-term options could have a portion of the cash tied up until expiration of the of the contracts. Liquidating at market value, in certain volatile circumstances could prematurely decrease the net asset value of the fund. However, a simple remedy that this SEC proposal prevents is including emergency redemption limits that simply permit these options to expire. For short-term contract funds, this might impose a 30-60 day dilution limit to ensure that highest market value of the net assets; and, this redemption limitation would only be invoked in an emergency. The prospectus should, of course, be required to make such scenarios clear.
Yet, while this market driven solution could create the best-case scenario for investors, permitting them to take the risk of the leveraged fund, with the hope of maximum redemption value in the worst case crisis scenario with the trade-off that they might have to wait for redemptions, the SEC has chosen to limit the options of the fund to prevent this possibility. In short, it will limit profit and hedging opportunities of retail customers in order to prevent a limit on the redemption time period in the case of dilution or rapid withdrawals.
The leaning of the SEC proposal towards cash and market value also precludes certain hedging opportunities the funds could take to protect the fund, hedging which technically increases total nominal exposure relative to cash, despite it being a hedge that protects the fund. For instance, a fund might decide to use far out-of-the-money (OTM) option contracts with underlying that have a negative correlation to the primary underlying to protect the fund from extremes. Yet, this type of healthy hedging could be prevented due to the method of accounting that the SEC is proposing. The SEC's over-simplistic view of cash and current market value does not consider true stress testing scenarios and protection capabilities uniquely available in the derivatives markets.
In an era where an individual investor can use tools to beta weight their portfolio to see how it will perform when the S&P 500 changes, you'd think the SEC could propose better stress testing than simply limiting notional value relative to cash and equivalents. Does a gold fund really need to worry about gold becoming worthless overnight? How does comparing the notional value of its gold exposure to its cash holdings really help?
What does matter with any notional exposure is the degree it can change, and whether a hedge is needed to handle extremes in its range. If we are worried about the risks of being heavily weighted against the S&P 500, for instance, we can reduce that risk better by investing in something that will likely have a negative correlation to the S&P, and can do that best through leverage. A high notional exposure to gold and volatility contracts can have a far greater risk reducing benefit for S&P 500 exposure than simply having a lot of underutilized cash available. Where in the SEC proposal does it provide the opportunity for this type of protective hedging?
The real issue here is that if the derivative based funds use derivatives to diversify and protect their net asset value, they could have less liquidity in the short-term due to the need to permit contracts to either reach a desired market value or expire. Yet, this is only limited by the length of their stated contracts, typically 30-60 days. This is further reduced by the degree to which their hedge increases in market value relative to the decrease in market value of their primary investments. In the case of volatility futures and options, their market value rises in sync with a drop in S&P market value, thus providing much better NAV protection than cash.
Of course, hedging has a cost, notably in good times, when the fund's primary investment strategy is working. This cost would have to be considered, and like any, publicized in the prospectus.
The SEC should not pass this new proposed set of rules limiting leveraged funds as it is currently worded. Rather, in the short-term, it should focus on investor education, improving prospectus reporting, and working with the markets to develop better stress protection using the free markets themselves to provide the solutions. Then, when the SEC has demonstrated a competence for understanding the derivatives markets it is proposing to regulate, maybe then it can create rules that permit market based solutions instead of basic accounting concepts. This would protect consumers in good times and bad, permitting them to make profits and hedge their portfolios with robust tools, while also permitting them to obtain the best possible redemption value should a crisis emerge.