SEC May Use 1940 Act To Rein In 170 Leveraged ETFs

A leveraged exchange-traded funded (ETF) offers investors and traders a leveraged exposure to the price performance of an index. For example, the Direxion Daily Financial Bear 3X Shares (NYSE: FAZ) is designed to offer an investment return approximately equal to 300 percent of the inverse (or opposite) of the price performance of the Russell 1000 Financial Services Index.

These type of leveraged ETFs are perfectly legal and commonly used among investors, traders and hedge funds. However, the Securities and Exchange Commission (SEC) is now taking a closer look at these products and may implement measures that would restrict how much mutual funds can invest in these products.

According to the Wall Street Journal, an SEC proposed rule could treat leveraged ETFs like mutual funds, which could impact hedge funds that take advantage of the ETFs over-sized gains (or losses). In addition, the SEC's Chairman Mary Jo White said in May that a final decision regarding the leveraged ETFs would be made this year.

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The Wall Street Journal added that the SEC could make use of a federal law passed in 1940 that controls how much debt investment funds can assume. In 2006, the SEC granted permission for ETFs to use derivative products that seek magnified returns that often come from using borrowed money. The justification at the time was that ETFs are similar to mutual funds but trade on stock exchanges.

"The SEC's rule suggests that '3x ETFs' may be 'unduly speculative' and clash with the 1940 restriction on how much mutual funds can borrow to finance investments," the Wall Street Journal explained. "It would cap the leverage created by a fund's use of derivatives to 150 percent of, or 1.5 times, its net assets. While the 1940 law was written long before most derivatives existed, the SEC has treated those assets like borrowing because they require only a small down payment to increase a fund's exposure to stocks, bonds or commodities."

Meanwhile, leveraged ETFs could be confusing for some novice investors who make the mistake of holding a product for longer period of times. The ETFs are designed for a daily performance, and over a longer period of time, the effects of daily compounding produce returns that are likely to be inconsistent with the ETF's objective.

For its part, Direxion, a large manager of leveraged ETFs, paid $8 million to settle a lawsuit in which shareholders alleged they were misled; the suite alleged the company failed to adequately explain the risks associated with holding the products over time.