Last Updated: 2 June 2023
As my colleague Murray Coleman points out in his latest blog on IndexUniverse.com, recent outflows from US leveraged and inverse ETFs suggest that we may be past the peak of the boom in this sector.
Yesterday, the SEC weighed into the debate over the suitability of these funds for retail investors, issuing a joint alert (with FINRA) with the catchy title, “Leveraged and Inverse ETFs: Specialized Products with Extra Risks for Buy-and-Hold Investors.”
Although I’m not a fan of leveraged ETFs and wouldn’t buy them myself, I have a sneaking admiration for the chutzpah of the managers at ProShares. Having faced a recent deluge of bad publicity regarding leveraged ETFs, sales bans by brokers who are clearly scared of misselling charges, and a class action lawsuit, ProShares said yesterday that they are “very pleased that the SEC and FINRA confirmed that the funds can be suitable to hold for periods longer than one day for a variety of strategies.”
Having written a feature yesterday on the implications of the recent debate over leveraged and inverse ETFs for the European market, I can see both sides of the argument regarding the suitability of these funds. If you want to gain a true inverse return on an index without suffering the problems caused by daily rebalancing (strictly, by the maintenance of a constant leverage ratio), then it’s better to borrow the relevant ETF and short it. Since tracking problems are magnified by the use of leverage (i.e., when you start using ETFs that offer 200% or 300% of the daily index return, or the inverse), the use of a traditional margin arrangement has clear advantages if you’re planning to hold the position for a while.
But what if the account you’re using doesn’t allow you to do this? I have a self-invested pension plan (SIPP), for example, and there simply isn’t the facility to short sell within it. I might well want to gain short market exposure within the SIPP from time to time, and here an inverse ETF would be my only option. I would stick to the simple (minus one times the index) version if I did, but in any case I’d much rather have these types of ETF available to me than not.
More broadly, it was clear from the interviews I conducted with European ETF providers that they are pursuing different strategies when trying to offer investors short market exposure. Some are concentrating on developing ranges of inverse ETFs whereas others are working on developing the market for ETF lending so that investors can borrow ETF shares and sell them short themselves.
In the same way that providers of swap-based and in-kind ETFs are competing to provide the best model for index tracking, the existence of two methods of providing short exposure is a good thing. Competition is good for investors, after all, as it leads to improvements in product design and downward pressure on fees. Let’s hope it continues, and that European regulators take a sensible approach to supervising this sector.