The Securities & Exchange Commission announced last week it is conducting a “review” of ETFs and mutual funds that make heavy use of derivatives in their portfolios. Pending the review, applications for new issues of such funds have been suspended. Existing funds may continue to operate normally.
This move is not directly related to last year’s decision by the Commodity Futures Trading Commission to enforce position limits on ETFs that use regulated futures contracts. You may recall that turmoil in commodity-related ETFs followed the CFTC action.
The SEC move is unlikely to have such an immediate impact but could pose a long-term problem. Sponsors who have built their business around leveraged, inverse, and commodity-based ETFs are particularly vulnerable since almost all such funds depend on various kinds of derivatives to execute their strategies. This category includes Direxion, ProShares, Rydex, and several smaller firms.
The SEC seems to be concerned that investors in these funds do not understand the additional risks. They are perfectly correct: plenty of investors obviously don’t know what they are getting into. That’s why they get angry and file lawsuits after they lose money, despite the many warnings and disclosures they apparently ignore.
My best guess is that the SEC will, following its review, allow ETFs to continue using derivatives, though maybe with some new restrictions and additional disclosures. Meanwhile, we probably won’t see any new leveraged, inverse, or commodity-based ETF launches. Exchange-Traded Notes (ETNs) fall into a different category, so we may see sponsors switch to that format in some cases.