March 27, 2016
I am a registered investment advisor with two decades of experience trading stocks, ETFs and options. I am writing to support the grandfathering (or exemption in some other form) of levered ETFs (LETFs) from the leverage limits proposed in Rule 18f-4. There are two primary points that I would like to make.
In the proposal, the SEC cites several instances of mutual funds failing or blowing up due to excess leverage incurred by the use of derivatives. In contrast, LETFs have never failed to deliver their mandate of delivering daily returns of X times (or -X times) the performance of the reference index. LETFs do exactly what they are designed to do. In doing so, they provide the general public, and retail investors, with capital efficient tools for trading and hedging that would otherwise not be available to them. Yes, over extended time frames, LETFs do exhibit significant tracking error to the reference indices, but this argues for proper disclosure and education, not eliminating them entirely.
This brings me to my second point. I am a very experienced options trader, and believe that options are much more dangerous to the average retail investor than LETFs. Investors are appropriately protected from the leverage and risk inherent in options through proper education and disclosure. I believe that similar steps can, and should, be taken with LETFs to protect naive investors from the risks associated with these instruments. For example, before an account gains permission to trade LETFs, the investor could be required to complete a succinct online course in the dangers of trading LETFs, both over short-term, and longer time frames.
The deep and liquid options markets that have developed over the past four decades provide investors, both large and small, institutional and retail, with an array of tools to hedge risk and express views on the market. LETFs provide similar benefits, and should not be eliminated by the blunt instrument of the leverage restrictions in proposed rule 18f-4. What may be appropriate restrictions on an open-end high yield bond, are not necessarily the right way to regulate an exchange traded equity fund. Education and disclosure are the appropriate way to protect the general public from the risks in these instruments.