SEC Adopts Rules to Prohibit the use of Leveraged/Inverse Funds

On October 28, 2020, the Securities and Exchange Commission approved a rule that will dramatically change the use of derivative instruments and certain related transactions by mutual funds, exchange-traded funds, closed-end funds, and business development companies.

SAF is opposed to the Commission’s adoption of Rule 18f-4, which represents an intrusive, burdensome, and expensive resolution that fails to properly define the problem of retail investors having access to leverage.

Derivatives are financial instruments whose values are derived from the fluctuations in an underlying asset, such as stocks, bonds, commodities, or interest rates. Rule 18f-4 was adopted as a response to the SEC’s concerns over certain mutual funds and ETFs utilizing derivatives to leverage the fund. Leverage allows a fund manager to use a small amount of capital to have exposure to a larger position. An example of leverage is the thirty-year mortgage, where a small down payment gives you the right to own a home.

Geared investment vehicles, such as leveraged and inverse funds, are often mislabeled as “speculative in nature” because they magnify returns in both directions. If a geared investment vehicle is 300% leveraged, a 1% move in either direction of the underlying asset would be a 3% move in the geared investment vehicle. However, these funds are practical and liquid investment vehicles used to hedge. Investing in a leveraged inverse fund is akin to buying insurance on your other investments and mitigating losses. Like most derivative instruments, the capacity to hedge investment risk can enhance the overall risk of the position.

Rule 18f-4 requires a fund to adopt and implement a written risk management program that fulfills six intrusive requirements as a prerequisite for initiating a derivatives transaction. Funds that transact with derivatives will also be required to hire a program risk manager. The creation of a staffed derivatives management program capable of conducting requisite stress testing, back-testing, internal reporting and escalation, and program review elements will require the use of costly compliance systems that will come at the expense of investors in the form of increased fees. The rule also puts an arbitrary cap on the exposure of a leveraged fund of 200%.

The moratorium on new greater-than-200% leveraged investment funds, while grandfathering in already established 200% leveraged funds, and as Barrons reports, creates a barrier to entry and further diminishes the ability for new business to offer Leveraged ETF products that reduce.

The Commission justified the implementation of Rule 18f-4 by citing the need for “meaningful protections for investors.” In practice, Rule 180f-4 will limit the right to access certain products in the public markets can be used to diversify an investor’s financial planning needs.

SAF supports the Commission’s decision to withdraw the proposed sales practice rules for investment advisers and broker-dealers as suggested in the proposed rule. This provision would have required investment managers and broker-dealers to conduct due diligence on their retail clients before approving retail investor accounts to invest in leveraged or inverse funds and cost the broker-dealer and investment adviser industry an astounding $2.4 billion.

SAF submitted comments to the SEC calling for the proposed rule to be withdrawn in its entirety or narrowly tailored to exempt certain ETF’s from elimination in the marketplace.