Leveraged ETF Blowups Draw SEC Scrutiny Amid Market Turmoil (2)

The U.S. Securities and Exchange Commission is stepping up its scrutiny of leveraged exchange-traded products as violent market swings have prompted a spate of complaints.

The surge in volatility amid the coronavirus pandemic has sparked a reckoning of sorts for leveraged products, which use derivatives to boost returns of the securities they track. While those contracts can boost gains, they tend to amplify losses as well. A total of 16 leveraged offerings liquidated last quarter, according to data compiled by Bloomberg, while others have opted to reduce leverage.

“It’s pretty obvious that there’s sort of a widespread lack of understanding of how those are intended to operate,” Rick Fleming, the SEC’s investor advocate, said in a call the agency held with an industry advisory group on Thursday. “The high volatility in the market has sort of exposed that lack of understanding that’s out there.”

Fleming said the agency has received numerous complaints from retail investors about those products as the pandemic rattled markets. While the SEC has been grappling for years with how to regulate securities that rely on leverage to juice returns, it’s yet to finalize rules that specifically address the products. In November, the agency put out a fresh proposal that would limit funds’ leverage.

The SEC said at the time that its new plan, which differed from an Obama-era proposal, would require firms to “exercise due diligence” in deciding whether or not to allow retail customers to buy or sell the leveraged products. Brokers and investment advisers would only be allowed to approve them for clients they believe capable of understanding the risks, according to the agency.

SEC Chairman Jay Clayton said Thursday that he is “keenly focused” on when leveraged products are suitable for retail investors, which the pending rule would seek to address.

“There’s a discussion in there about ETFs and whether retail investors do in fact understand them and what we should do about that,” Clayton said. “Those types of products, in many scenarios, have analogous pay-off matrices to options, and as we all know trading in options requires some level of sophistication.”

The SEC’s press office didn’t respond to an emailed request for additional comment on issues raised by Clayton and Fleming during the call, which was open to the public.

The issue of mom-and-pop investors getting hit with big losses by the products when market volatility picks up came to the forefront in February 2018. At the time, Bloomberg News reported that regulators probed whether wrongdoing contributed to steep losses for VIX exchange-traded products offered by Credit Suisse Group AG and other firms.

Now, as stocks flip between swooning and surging and crude prices gyrate, leverage-heavy exchange-traded products are back in the spotlight. Citigroup Inc. and UBS Group AG returned cash to holders of their triple-leveraged oil exchange-traded notes in late March, while Credit Suisse warned that “complete loss” was likely for future buyers of one of its similar products on Thursday.

Citigroup, UBS and Credit Suisse declined to comment.

Despite the shake-out, demand for the leveraged offerings has been robust. The two major issuers of those products, which trade under the ProShares and Direxion brands, each posted inflows of nearly $4 billion in March, according to data compiled by Bloomberg Intelligence. That put both within striking distance of Vanguard’s $4.3 billion haul, while BlackRock saw outflows of roughly $9 billion.

(Updates with response from UBS.)

To contact the reporters on this story:
Ben Bain in Washington at bbain2@bloomberg.net;
Katherine Greifeld in New York at kgreifeld@bloomberg.net

To contact the editors responsible for this story:
Jeremy Herron at jherron8@bloomberg.net

Rita Nazareth, Dave Liedtka, Gregory Mott

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