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Statement of Commissioner Robert J. Jackson, Jr. on Proposed Rules Regarding Exchange Traded Funds (ETFs)

June 28, 2018

Thank you, Chairman Clayton, and thank you to the terrific Staff in the Division of Investment Management for their work on today’s proposal. I’m especially appreciative to Zeena Abdul-Rahman, Joel Cavanaugh, John Foley, Jay Krawitz, Melissa Gainor, Brian Johnson, Sumeera Younis, Sarah ten Siethoff and Christian Sandoe for the time you spent with me throughout this process.

This proposal brings some much-needed consistency to oversight of exchange-traded funds, a multi-trillion asset class that we have regulated only through the exemptive-order process until today.[1] These products, which are now at the heart of millions of Americans’ savings and retirement plans, are too important to too many investors to regulate through a patchwork of individual determinations.[2]

So I’m proud of the Staff for bringing this proposal before us today.[3] But I can only reluctantly vote to propose this rule. The reason is that the proposal does nothing to address a growing group of products, known as leveraged ETFs, that pose real risks to American families who are saving for the long term. I’m concerned that we are not doing enough to protect American investors from those risks.[4]

Leveraged ETFs are sometimes sold to investors on the promise that they will deliver a multiple, for example three times, of the returns of a particular index. While leveraged ETFs can be useful in some contexts, they are rarely appropriate for everyday investors saving for their families’ futures.[5] The reason is that investors in leveraged ETFs suffer large losses in volatile markets. And I’m worried that many investors are going to find out—too late—exactly how dangerous these products can be.

Imagine an American worker concerned that her savings are not enough for her retirement. She decides that, rather than investing in a more standard indexed mutual fund, she should invest in a product that gives her three times the return of that index. Suppose that she takes $10,000 of her precious retirement dollars and buys a three-times leveraged ETF, and that the index she’s chosen goes up five percent on the first day, down nine percent on the second, and up five percent on the third.[6] After those first three days, the index will have earned about $33, so our investor might think she’s earned $99.[7]

But actually this investor will have lost nearly $350, because the rebalancing in leveraged ETFs generates losses under conditions like these—and the longer they hold them, the worse these effects get.[8] I am concerned that Americans families will buy and hold products like these on the expectation that they are sound investments over the long term—only to find out, too late, that they’re not.

Those who advocate for these products have provided two reasons why we shouldn’t be worried about them, and although I remain open to arguments in this area I am concerned about both claims.[9] The first is that the average holding period for leveraged ETFs is, in fact, relatively short. That may be, since sophisticated institutions trade these products at high speed, but my concern is not about the average holding period in leveraged ETFs.[10] Instead, my concern is that a particular group of investors—especially those nearing or at retirement—may hold these products for far longer than they should.

The second reason advocates give for us not to worry about these products is that, in recent years leveraged ETFs have actually outperformed more standard index funds—even when they’ve been held over the long term. But that’s only true because we have recently experienced relatively calm, and rising, markets. In times of market volatility, however, investors can and will get hurt by these products. And our job is to protect investors in both good times and bad.[11]

That’s why I’m delighted to report that I have expressed these views to Chairman Clayton, and he shares my concern that these products can pose a real danger to American investors. We hope to work together to study this question—starting with hard empirical data that can tell us whether there are a significant number of retail investors who are exposed to the risks I’ve described.

Today’s proposal is a step in the right direction, but we need to do much more to protect investors in this area. I very much look forward to working with the Chairman and my colleagues on the Commission toward developing a comprehensive and clear approach to these increasingly important products.

[1] See, e.g., Record Inflows Boost Global ETF Assets to $4.3 Trillion, With BlackRock Leading the Way, Forbes (Aug. 23, 2017).

[2] In important recent work that has significantly informed my thinking in this area, Henry Hu and John Morley explain that the exemptive-order process has created an uneven competitive landscape in which one fund may be allowed to take an action another may not—even if they offer very similar products to investors. In practice, this has meant that certain funds—especially older, more established funds—can take actions that newer funds cannot, making it difficult for newer funds to compete. See Henry Hu & John Morley, A Regulatory Framework for Exchange-Traded Funds, 91 S. Cal. L. Rev. ____ (forthcoming 2018).

[3] I am concerned that today’s vote does not bring share-class ETFs into the more universal ETF regime that we propose today. Ideally, the level playing field we seek to establish today should apply to all participants in these important markets. But I recognize that resolving those issues will require a substantial amount of work, particularly with respect to tax-related matters. I hope the Commission will work toward addressing those issues in the future.

[4] See, e.g., Matt Levine, SEC Wants Exchange-Traded Funds to be Easy to Trade, Bloomberg View (Oct. 23, 2014) (“[T]here are ETFs that . . . giv[e] regular investors exciting ways to lose money trading levered products they don’t understand.”).

[5] To be sure, these products can have well-known and important institutional uses, for example for intraday liquidity. My focus here is, as I believe it should be, on the risks the products pose to ordinary retail investors.

[6] This example is, of course, merely illustrative of the risks of these products, and reflects an ususual and nonindicative level of market volatility.

[7] In this example, the investor’s balance will have increased from $10,000 to $10,500 on the first day, fallen to $9,555 on the second day, and risen to $10,033 on the third day. Imagining that she has bought “three times” exposure to the index, then, the investor might conclude that she has earned three times her $33 profit after these three days—or $99 total.

[8] To see why the investor will have lost money—even though the index has risen in value—note that the investor’s balance in the three-times levered ETF will have risen to $11,500 after the first day, fallen to $8,395 after the second day, and risen again to $9,654 after the third day, resulting in a loss of approximately $346.

[9] There is a separate, and important, debate about the degree to which these products may pose broader systemic concerns. See, e.g., Ivan T. Ivanov & Stephen L. Lenkey, Federal Reserve Board Finance and Economics Discussion Series 2014-106; compare Kevin Pan & Yao Zeng, ETF Arbitrage Under Liquidity Mismatch (working paper June 2017). In this statement, however, I focus on the investor-protection concerns presented by these products.

[10] Actually, the relatively little evidence we have with respect to holding periods seems to point in the opposite direction. See, e.g., Ilan Guedj, Guohua Li and Craig McCann, Leveraged ETFs, Holding Periods and Investment Shortfalls 12 (2010) (“The percentage of investors that we estimate hold these short term investors longer than a month is quite striking.”).

[11] Apologies: Now that I’ve been engaged to be married for a few months, I find myself writing lines like these more often than I otherwise might. See, e.g., 2 Catechism of the Catholic Church § 2, Ch. 3, Art. IV (providing the traditional basis for the vow to care for one’s spouse “in good times and in bad, in sickness and in health”); see also Led Zeppelin, Good Times Bad Times (Atlantic 1969) (discussing the existential nature of both “good times and bad times”).

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