Leveraged ETPs: 150% "Speed Limit" by Law. SEC Proposes New Derivatives Rules.
Our Washington colleagues from the Securities and Exchange Commission produced–after three years seeking public comment– some new guidelines for the usage of derivatives in funds, incl. Leveraged ETFs/ETPs on Friday last week. Short before the Holiday Season each and every institutional user of derivatives got a little gift.
The news not only drew attention within the financial media like WSJ and Bloomberg, but also high-caliber publications like POLITICO put the derivatives limitations on their front page.
Here the entertaining version of the SEC’s new rules:
SEC rules could limit investments popular with some members of Congress
By Patrick Temple-West 12/10/2015 10:16 AM EDT
Proposed rules the SEC will debut on Friday could change how individual investors - including some members of Congress - can speculate on financial markets. The SEC's rules may limit how much leveraged exchange-traded funds can use derivatives, on the theory that the complex financial instruments are not intended for retail investors, sources have told POLITICO. Earlier this year, SEC Chair Mary Jo White said these fund rules would limit the leverage that derivatives can generate.
Leveraged ETFs rely on derivatives to juice up returns, so restrictions on derivatives in the SEC's proposal could have indirect consequences for these products. Still, an analysis of 2014 congressional disclosures offers a glimpse into how retail investors haven't been deterred from taking on the risk of leveraged ETFs despite warnings from regulators. Rep. Alan Grayson, a Florida Democrat running for the state's open Senate seat and one of Congress' most active traders in the financial markets, frequently trades leveraged ETFs, his disclosures show. Grayson, who declined to comment for this story, reported using a ProShares ETF to earn more than $100,000 last year. It's unclear how he fared overall in trading leveraged ETFs because only his taxable earnings were reported.
ProShares, a Bethesda, Md.-based company that's the largest provider of leveraged ETFs, has said its products are not designed for mom-and-pop investors, but rather pension funds and other big portfolio managers who need to manage risk. Hazards for individual investors are evident. Sen. Richard Burr (R-N.C.) reported unrealized losses of $32,866 on a triple-leveraged ETF, according to his 2014 disclosure. A spokeswoman for Burr declined to comment.
Leveraged ETFs offer investors a way to double- or triple-down on underlying assets like oil futures or home-building companies. Over time, these ETFs can fluctuate dramatically from the value of the underlying index, a characteristic that can expose buy-and-hold investors to big losses. Soon after the SEC approved the first leveraged ETF in 2006, the products began drawing scrutiny from regulators and investors. From March 2010 to December 2012, the SEC stopped approving new leveraged ETFs, citing concerns about their use of derivatives. And the agency has warned the public about the risks of buy-and-hold investing with leveraged ETFs.
There are currently 275 leveraged ETFs available, up from about 150 in 2010, according to ETF Radar Research & Advisory LP. ProShares is the largest leveraged ETF provider, followed by Direxion. Both companies declined to comment ahead of Friday's vote. Grayson, who is running to replace Sen. Marco Rubio, can absorb losses more readily than many investors. He had an estimated net worth of $60 million in 2014, making him the 10th-wealthiest member of the House, according to the Center for Responsive Politics. He's the eighth-most prolific trader in Congress, and by far the largest user of leveraged ETFs, according to a CRP analysis for POLITICO. "The strategy seems to be paying off for him as he's made tens of thousands of dollars trading in financial instruments that most Americans have never even heard of," said Dan Auble, a senior researcher at CRP.
Given the well-known dangers of leveraged ETFs, they should come with warning labels like cigarettes, said Todd Rosenbluth, an ETF researcher at S&P Capital IQ, a data provider. "The purpose of them is mostly geared toward someone making a short-term bet on an investment sector or overall market for a day," Rosenbluth said. "There are significant risks. A volatile market can be in your favor and then out of your favor very quickly," he said. "There's nothing stopping you and I from buying these products."
"The SEC is well-advised not to demonize all leveraged ETFs," said Martin Raab, a co-founder of ETF Radar. The agency should require sellers of these products to consistently describe the risks, he said. "If somebody wants to drive 100mph with [a] brand-new Porsche, you can't sue the dealer for selling him this high-powered vehicle," Raab said. "It's the driver who is responsible."
Here comes the sober analysis of the new rules and what it means in the daily practice:
Portfolio Limits
Proposed rule 18f-4 would require funds to comply with one of two alternative portfolio limitations that would limit their ability to obtain leverage through investments in derivatives and certain other instruments. Exposure-based portfolio limit. A fund would be required to limit its aggregate exposure to 150% of the fund’s net assets. “Exposure” for these purposes generally means the aggregate notional amount of the fund’s derivatives transactions, together with the fund’s obligations under “financial commitment transactions” (such as reverse repurchase agreements and other similar transactions).
Risk-based Portfolio Limit
Alternatively, a fund could obtain “exposure” by means of derivatives in an aggregate notional amount up to 300% of the fund’s net assets, provided that the fund satisfies a risk-based test based on value-at-risk, or VaR. This test would determine whether a fund’s derivatives transactions, in the aggregate, result in a portfolio that is subject to less market risk than if the fund did not use derivatives. By the way: If you have further questions on independent valuation, just drop me an email.
Asset Segregation for Derivatives
In addition to the portfolio limitations, the Commission would require funds to manage derivatives risks by segregating liquid assets (generally cash and cash equivalents) equal to the sum of the following two amounts. Mark-to-market coverage amount. A fund would be required to segregate assets at any time equal to the amount that the fund would pay if it exited the derivatives transaction at the time of the termination.
Risk-based Coverage Amount
A fund also would be required to segregate an additional risk-based coverage amount. This “cushion” would represent a reasonable estimate of the potential amount that the fund would pay if the fund exited the derivatives transaction under stressed conditions.
A new colleague: Derivatives Risk Manager
Funds that engage in more than limited derivatives transactions (exceeding 50 percent of net assets), or that use complex derivatives, would be required to establish and maintain a formalized derivatives risk management program and designate a “derivatives risk manager,” both segregated from the fund’s portfolio management operation and approved by the fund’s board of directors. The program must be reasonably designed to assess the risks of derivatives transactions, manage and monitor risks, and require periodic updates and reviews, among other things. In addition, the rule would require fund boards to review written reports prepared by the derivatives risk manager, at least quarterly, and review the adequacy and effectiveness of the derivatives risk management program.
Here is the SEC’s PR version of the news aka “Official Press Release: http://www.sec.gov/news/pressrelease/2015-276.html