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Tuesday, March 30, 2010

Why is the SEC suddenly focused on leveraged ETFs?

The SEC has decided to take a closer look at derivatives as they are used by ETFs and mutual funds.

Here is what the SEC has said:
"Pending the review's completion, the staff has determined to defer consideration of exemptive requests under the Investment Company Act to permit ETFs that would make significant investments in derivatives. The staff's decision will affect new and pending exemptive requests from certain actively-managed and leveraged ETFs that particularly rely on swaps and other derivative instruments to achieve their investment objectives. The deferral does not affect any existing ETFs or other types of fund applications."
I used to write regularly about ProShares leveraged ETFs. Under the hood, leveraged ETFs, both the 2X or 3X and inverse 2X or 3X, make extensive use of derivatives. Swaps of one kind or another are commonly utilized to achieve results that are multiples of an underlying index.

Let's look at the ProShares Ultra QQQ (QLD) ETF that is intended to deliver twice the daily performance of the NASDAQ 100 index. According to the ProShares site, QLD daily holdings include over $200M in futures and nearly a $1B (notional value) in swaps. This is in contrast to other holdings of approximately $500M in the actual stocks that make up the NASDAQ 100 plus $340M in cash and other assets. Needless to say, it's primarily the swaps that gives this ETF its juice.

In effect then, a company like ProShares would not be able to bring to market any more leveraged ETFs. Fortunately for ProShares, the SEC announcement indicates that existing ETFs will not be affected.

Who does this SEC decision actually hurt?

Institutions always have more opportunities to use complicated or exotic investment techniques so the SEC decision will be merely an inconvenience.

Once again, it is the small investor who will see less choice in investment products. Sector and style-based ETFs have made it much easier for individual investors to make diversified bets on different areas of the U.S. and global economies. The leveraged long and short ETFs have been good vehicles for reasonably educated traders with a more short-term orientation.

So why all of a sudden the interest in leveraged ETFs? Is the SEC responding to political pressure to make it look like they are doing something about the barely regulated derivatives market? Is it easier to just dump on providers of ETFs and mutual funds than to actually go up against the investment banks and hedge funds that are primary players in the derivatives markets?

Read the SEC Press Release here.

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