SEC Chases ETF Boogeyman: Geared Funds

This week the Wall Street Journal wrote an article suggesting that the SEC might come out Friday and shut down all leveraged and inverse ETFs.

This would be a bold move for a regulator that, generally speaking, hates to actually disrupt whole product lines. After all, it's not like in 2008 when collateralized mortgage obligations and their derivatives ceased to exist, there were just new rules about who could issue them and how much risk they could take.

Regardless of what they do or don't say this week, or next week, or next month, it's worth understanding what all the fuss is about.

It's really about swaps, investor education and volatility.

The Swaps

Leveraged and inverse ETFs (and exchange-traded notes) seek to go up or down in value based on some ratio to an underlying asset (the gearing) over a particular time period (typically one day.)

Imagine you want to be invested in the S&P 500. You could buy one of several S&P 500 ETFs. If you were really sure the S&P 500 were going to go up today, well, you could by a leveraged S&P 500 ETF that would promise you 200% of the index's daily returns. If the S&P 500 goes up 1% for the day, you'd go up 2%. If you were sure the S&P 500 was going to tank, you could make the opposite bet and buy an inverse-leveraged ETF that goes up when the index goes down.

If it sounds magical, it's not really. Structurally, most of these funds are just 1940 Act-registered mutual funds, like Fidelity Magellen or the Growth Fund of America. But instead of owning stocks, they own just two securities. First, they own a giant pile of cash. Second, they own a swap contract on the S&P 500.

Swap contracts aren't traded on an exchange, like options, so they're considered "over the counter" or negotiated derivatives. The ETF issuer calls up a big bank, like Goldman Sachs, and says "I would like to make a bar bet. Every day, if the S&P 500 goes up 1%, you give me 2%, and if GDX goes down 1%, I'll owe you 2%." Every night, the issuer and the bank check out who won the bet, and cash moves from one side of the betting logbook to the other.

What's Wrong With Swaps?

There's nothing inherently evil about swaps, but it does raise a few eyebrows with regulators and skeptical investors. There is one big issue: transparency.

First, investors generally don't know anything about the costs or risks of the swaps they're owning through the ETF. While the funds hold the cash, there's a non-zero risk that the swap counterparty could literally go bankrupt overnight, and not make good on moneys owed on a day the bet was going in the funds favor.

That counterparty risk may be low, but it's not nothing. And unlike, say, options, there's no exchange standing in the middle to aid with settlement. Furthermore, there's no disclosure of how much the issuer is paying for the swap (which comes out of your experience as an investor) or what policies are in place to handle things like overnight settlements or errors. In practice, none of these things has been a huge problem yet, but they exist as potential boogeymen.

Investor Education

The thornier issue is one of expectation management. Because leveraged and inverse funds promise (with few exceptions) geared returns for a single day, they often don't perform anything like you might expect over longer periods of time.

After settling up the bar bet every day, the fund has to reset it's exposure so it will deliver the same pattern of returns it did the day before. If a fund is promising -2X returns on a $100 investment, that means it needs a swap providing -$200 in exposure each morning before the market opens. If the market goes up 10% that day, well, the -$200 becomes $-220, and the value of the investment is now $80. But tomorrow, I need -$160 in exposure. To do that, I unwind part of the swap, and reset the bar bet.

When you carry this math out over a long period of time, a curious thing happens: if the index being tracked is volatile, investors do worse over time than a naïve person might think (you won't get -20% returns if the market is up 10% over a year, using the above -2X example, you might get -30%). If the market is very non-volatile, you can actually do better (say, being down only 15% when you "should" be down 20%).

This can lead to some very problematic charts. Consider how the -3X and +3X gold miners ETFs have done year to date:

The underlying asset being tracked here is represented by the Market Vectors Gold Miners ETF, which has had a rough year, down some 23%. And indeed, the ETF that gives you triple that exposure, the Direxion Daily Gold Miners Bull 3X, has been crushed, down almost 75% on the year. But the irony is, because of gold's incredibly volatile year, the INVERSE fund,Direxion Daily Gold Miners Bear 3X, is not up 75%, as you might expect, it's actually down more than the regular old 1X unlevered ETF!

There's nothing nefarious here. Sure, some of the slippage comes out of expense ratio and the cost for the swaps, but ultimately, this is just the merciless nature of mathematics at work. These funds do, generally, exactly what they say they're going to do – for one day at a time.

This is the biggest problem the SEC faces: investors often don't understand this math. Sure, hedge funds and institutions do, but the average investor or advisor? Despite a six year education effort pushed very had by FINRA and the ETF issuers themselves, I still get calls about charts like this all the time

But will the SEC actually close down for "investor protection" reasons? It seems unlikely.

The Last Boogeyman: Volatility

There is one final boogeyman, and that's the argument that geared funds are increasing market volatility. There is a kernel of potential truth to this argument. Structurally, leveraged and inverse funds have to be buyers when the market is going up and sellers when the market is going down. This may seem paradoxical, but whether I'm promising you 3X or -3X exposure to the S&P 500, if it's up on the day, my reset trade will be to get a swap for more positive exposure (reducing the negative swap, increasing the positive swap).

Of course, the ETFs themselves aren't buying stocks to do that, but somewhere down the chain, whether it's the swap provider to the ETF, or someone who then sells a futures contract of the swap provider, someone is increasing their beta exposure at the end of the day on a n up day, and reducing it on a down day.The fancy term for this is "procyclicality" and indeed, in any system, a procyclical input increases the amplitude of perturbation. All very fancy words to say "yep, more volatile."

The problem is simply one of scale. As I type this, the entire complex of leveraged and inverse ETFs has roughly $42 billion across 274 funds. About $23 billion of that is in U.S. equities. Even on a big day, say, a 5% move, that means that $23 billion would need about a $4.6 billion rebalance trade (the absolute average leverage factor is right around 2). Given that the average trading day in the us is now well over $250 billion, it requires some significant tail-wagging-the-dog stories to get too in a tizzy about the impact of rebalance trading.

Conclusion

It's not clear to me which of these three boogeymen the SEC is chasing, but I suspect the pressure on them is coming from all three camps: the investor protection, counterparty risk and market volatility angles. Of the three, both counterparty risk and investor protection can be addressed through transparency requirements, gating strategies (like options and futures requiring additional agreements by end investors), and broker regulation through FINRA.

The volatility argument? Well, despite how it looks on paper, every study I've ever seen or run myself suggests that while there is a theoretical chance for geared funds to cause chaos at the close, the well known nature of the rebalancing has dampened any effect. It's simply not true that the last 15 minutes of the market either increases or decreases in momentum with any regularity, at least not that I've seen.

So my perspective? By all means, let's get some light on the subject. But I think the SEC will likely need to find a different windmill to tilt at if they're planning on shutting down this particular part of the market.