Advisers reassess leveraged ETF plays as regulators freeze new risk and defer short-sale scrutiny
Wall Street’s riskiest ETFs just hit a regulatory wall, even as new transparency rules for short sellers get pushed years into the future.
The US Securities and Exchange Commission has paused reviews of a new wave of highly leveraged exchange-traded funds and is demanding more detail on how issuers measure risk, according to Reuters.
The letters effectively block proposed products that aim to deliver two or three times the daily returns of stocks, commodities and cryptocurrencies.
According to Bloomberg, staff in the SEC’s Division of Investment Management sent and publicly posted nine near-identical warning letters on the same day, an unusually fast move for an agency that typically waits 20 business days before releasing such correspondence.
The letters went to providers including Direxion, ProShares, Tidal and GraniteShares.
Reuters reported that in its letters, the SEC said it was “express[ing] concern regarding the registration of exchange-traded funds that seek to provide more than 200 percent (2x) leveraged exposure to underlying indices or securities”.
The regulator told issuers it would not proceed with reviews unless they either revise their strategies or formally withdraw their applications.
Reuters said the SEC’s concerns stem from Rule 18f-4 under the Investment Company Act of 1940, which requires a fund’s value-at-risk to remain below 200 percent of the value of an appropriate reference portfolio.
The regulator has asked managers to explain how they select the reference portfolio used to measure leverage risks, and suggested they adjust their strategies to comply or pull their filings.
Bloomberg reported that a central concern for the SEC is that some funds appear to be benchmarking risk against portfolios that may not fully reflect the volatility of the assets they aim to amplify.
The products under scrutiny sit at the extreme end of a broader trend toward higher-risk strategies, combining high leverage, daily resets and exposure to volatile areas such as single-name stocks, digital tokens and cryptocurrencies.
Leveraged products use options to amplify returns and have surged in popularity since the pandemic as traders look for an edge in fast-moving markets, with assets climbing to about US$162bn.
Reuters noted that leveraged ETFs, often favoured by retail investors, have “exploded in popularity” amid bullish sentiment, speculative trading and product innovation around single stocks and cryptocurrencies.
That growth has produced both standout winners and severe losses.
The largest leveraged ETF, the US$31.3bn ProShares UltraPro QQQ ETF, which targets three times the daily performance of the Nasdaq 100 index, has gained close to 40 percent this year.
By contrast, the Defiance Daily Target 2x Long MSTR ETF has plunged more than 83 percent, while an ETF tracking twice the performance of Super Micro has dropped more than 60 percent, and a 2x long cannabis ETF is down 59.4 percent, according to Reuters.
At the same time, the SEC has delayed implementation of new short-selling and stock lending disclosure rules by several years, Bloomberg reported.
Investment managers now have until 2 January 2028 to comply with short-sale reporting, and until 28 September 2028 for related stock lending disclosures, under an order issued Wednesday.
The SEC adopted the rules in October 2023.
They require certain investment managers to report short-sale data on a monthly basis, while pension funds, banks and institutional money managers that lend their stocks must report lending transactions the next day.
Trade groups including the Managed Funds Association and the Alternative Investment Management Association challenged the rules in court, arguing that they were inconsistent and exceeded the SEC’s authority.
In August, a three-judge panel of the 5th US Circuit Court of Appeals ruled that the SEC did not fully consider the economic impact of the rules and instructed the agency to reconsider.
Bloomberg reported that in its latest order, the SEC said the temporary exemptions are “necessary in the public interest and consistent with the protection of investors.”
However, SEC Commissioner Caroline Crenshaw, the commission’s lone Democrat, issued a statement warning that the extensions risk becoming “repeal by extension” that could indefinitely delay compliance.
Crenshaw said the court’s ruling was a narrow directive, not a message to abandon the rules, and argued that “under the guise of compliance date extensions, we are attempting to camouflage a new willingness to repeatedly bend the rules until they break — eroding the rule of law.”
