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Why the SEC Shouldn't Reject 4x Leveraged ETFs

  • (0:30) - ForceShares: Quadruple Leveraged Funds?

  • (2:45) – 3x Funds With Big Swings Right Now

  • (4:40) – Are the S&P 500 4x Funds the Limit?

  • (6:55) - Why is There So Much Concern With 4x Funds?

  • (8:10) - Episode Roundup: Podcast@Zacks.com

For quite some time, 3x/-3x funds have been the ceiling for traders in the ETF world. These funds give investors exposure to 300% or -300% returns of a benchmark over a single trading session, making them great hedging tools and short-term trading vehicles.

But ForceShares looks to jump into the leveraged ETF world with the first 4x and -4x products in the market. Their initial ETFs look to be UP targeting 400% the daily return of the S&P 500, and DOWN targeting -400% of the daily return of the S&P 500. In other words, if the S&P 500 moves higher by 1% in a given session, UP can expect to produce a 4% return (while DOWN would lose 4%).

Initially, the SEC approved these proposed funds, but there was an immediate outcry from people across the financial media and ETF world against this decision (see more about the SEC decision on quadruple leverage ETFs here). Some feel that this opens the floodgates for 5x, 7x, or even 10x products down the line, while others feel that this isn’t really in the best interest of investors.

The SEC has since gone back and put these products up for review again, and now the future of the 4x space is in doubt. But in today’s Dutram Report podcast, I take a closer look at why this is unwarranted, and why these funds are really no different than a number of other things on the market today.

Why Not Approving is a Mistake

There is no reason to prohibit the adoption of 4x/-4x funds in today’s market, as the only reason to stop the launch is in a misguided attempt to protect investors from themselves. This investor protection argument rings hollow though, and that is because if people were really concerned about investor protection, we wouldn’t have a number of other Exchange-Traded Products that we do right now.

Take for example 2x leveraged volatility products, UVXY and TVIX. Both of these products have lost more than 70% in the first five months of the year, and are arguably subject to bigger single day drawdowns on a more regular basis than a 4x fund would be. And while daily rebalancing would be an issue for quadruple leveraged products, no one seems concerned about a product like VXX, which has been around for years and faces regular contango issues, but is down nearly 99% in the past five years (also read Why I Hate Volatility ETFs (And Why You Should Too)).

But what about on the equity side? We have seen some crazy moves in plenty of stock segments as of late too! I talk in greater detail about this in the podcast, but two that stand out are LABU and BRZU. LABU is a triple bull biotech ETF, while BRZU is a triple leverage Brazil ETF. With political troubles in Brazil, the fund fell roughly 50% in a single session, while the one year chart for LABU speaks for itself in terms of rapid swings:

Is the SEC really protecting investors by allowing these funds but then also rejecting a 4x blue chip product? I don’t think that really adds up, and especially with some of the volatile moves we have seen as of late in the products listed above.

My point is that there is a bit of a double standard out there. Plenty of very risky funds already exist in the ETF world, and no one seems to mind. But, if you introduce the idea of quadruple leverage, even on blue chip stocks, everyone panics. It doesn’t make any sense, and it isn’t a good reason to prevent traders from using 4x leverage in exchange traded form if they see fit. 

Other Factors

In the edition of the Dutram Report, I also talk about why I think 4x/-4x funds will be the limit, and why we are unlikely to see a big suite of 4x funds in the near future. The volatility will likely be too great, and especially in wild market sectors like natural gas or gold mining (also read Ten Predictions for the ETF Industry in 2017).

I also talk about the real losers in this situation, and that is the current crop of 3x/-3x funds. These products-- which include UPRO, SPXL, SPXU, and SPXS—possess a combined $2.5 billion in assets and could lose their appeal if 400% leverage hits the market. That could be a big issue for some entrenched providers, and I discuss this in a bit more detail, as well as why 2x funds shouldn’t be that impacted by potential launches. So, make sure to check out the podcast for additional information!

Bottom Line

But what do you think about quadruple leverage ETFs? Should the SEC ban these products or do you agree with me on this topic? Make sure to write us in at podcast @ zacks.com or find me on Twitter @EricDutram to give us your thoughts on this, or anything else in the fund market.

But for more news and discussion regarding the world of investing, make sure to be on the lookout for the next edition of the Dutram Report (each and every Thursday!) and check out the many other great Zacks podcasts as well!

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PRO-ULT VIX STF (UVXY): ETF Research Reports
IPATH-SP5 VX ST (VXX): ETF Research Reports
DIRX-LC BULL 3X (SPXL): ETF Research Reports
PRO-ULT S&P500 (UPRO): ETF Research Reports
VEL-2X VIX ST (TVIX): ETF Research Reports
PRO-ULT SH S&P5 (SPXU): ETF Research Reports
DIR-D SP5 BR 3X (SPXS): ETF Research Reports
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