SEC Halts Launch of Ultra-Leveraged ETFs, Citing Investor Risk
Regulators signal a crackdown on speculative products, forcing issuers like ProShares and Direxion to withdraw plans for 3x to 5x leveraged funds.
The U.S. Securities and Exchange Commission is putting the brakes on Wall Street's push into increasingly speculative exchange-traded funds, effectively halting the creation of new products that use high levels of leverage.
The regulator has warned ETF issuers that it will not approve new funds planning to offer three-to-five times the daily return of their underlying assets, citing significant investor protection concerns and market stability risks. The move represents a significant regulatory crackdown on a niche but growing segment of the market known for its high-risk, high-reward nature.
Prominent issuers in the leveraged and inverse ETF space, including ProShares and Direxion, have been forced to shelve their latest ambitions. Following the SEC's intervention, ProShares has begun withdrawing several applications for highly leveraged products, some of which were designed to offer triple the daily returns on technology giants and cryptocurrency assets, according to recent reports.
The SEC's tougher stance appears rooted in existing regulations, specifically Rule 18f-4 under the Investment Company Act. This rule generally limits the leverage an open-end fund can employ, capping its risk exposure at 200% of the reference portfolio's risk. While 2x leveraged funds fall within this guideline, the regulator has signaled that it will not permit products that exceed this threshold.
In a series of letters sent to at least nine fund issuers, the SEC advised them to either revise their strategies to comply with the 2x limit or withdraw their proposals altogether. This directive has stalled the pipeline of new product launches and established what many see as a firmer boundary around product complexity and risk.
Leveraged ETFs are complex financial instruments designed for sophisticated traders and are not intended for long-term investment. They use derivatives like swaps and futures to amplify the daily returns of an index or asset. However, their performance can diverge significantly from the underlying asset over longer periods due to the mechanics of daily rebalancing, a phenomenon known as volatility decay. This can lead to substantial losses for buy-and-hold investors who may not fully understand the product's structure.
The regulatory pushback comes as investor appetite for these products has grown in volatile markets. Critics have long warned that their complexity poses a danger to retail investors who might be lured by the prospect of outsized gains without appreciating the associated risks of rapid, amplified losses.
While the SEC's action currently affects only new fund applications, it casts a shadow over the entire high-leverage ETF industry. The decision signals a more cautious approach from regulators, prioritizing market stability and investor safety over product innovation in the riskiest corners of the fund landscape. For now, the dream of 5x daily leverage remains just that, as the SEC makes clear that there is a limit to the level of risk it is willing to see packaged for public consumption.