Earlier this month we were somewhat surprised when the SEC blatantly ignored numerous complaints and approved a request to trade new quadruple-leveraged exchange-traded funds, the so-called ForceShares Daily 4X US Market Futures Long and Short Funds, the first such products of their kind.
The request to list ForceShares Daily 4X US Market Futures Long Fund, under the ticker UP, and ForceShares Daily 4X US Market Futures Short Fund, under the far more appropriate ticker DOWN, was filed by the NYSE Arca exchange. One of the funds is designed to deliver 400 percent of the daily performance of S&P 500 stock index futures, while another fund will aim to deliver four times the inverse of that benchmark. That means that - in theory - a fund could go up 8 percent on a day the index it tracks falls by 2 percent. However, due to the rebalancing nature of such products, it most likely won't, and instead will be used as another massively shorted vehicle by all those pension funds who scramble to capture the volatility roll "dividend" from markets that no longer see any risk, anywhere.
Leveraged ETFs employ derivatives to deliver two or three times the daily price moves of benchmarks. The ForceShares quadruple-leveraged funds would be the first to move beyond 'uber-conservative' triple leverage products which simply no longer pack enough volatility for today's Wall Street gamblers.
The SEC’s approval of the 4X funds on May 2nd appeared to signal, shockingly, that the SEC’s view of risky ETFs had changed after former Chairman Mary Jo White stepped down in January. White led an effort to crack down on the use of leverage by mutual and exchange-traded funds, but the approach wasn’t popular with Republican lawmakers or regulators.
“I was surprised they [the staff] let them go,” said Amy Doberman, a partner at Wilmer Cutler Pickering Hale & Dorr LLP who was previously general counsel of ProShares, a leveraged ETF provider. “They are certainly not any less risky. I cannot imagine they are going to be any less susceptible to the impact of volatility that caused issues with the other [leveraged] funds.”
But, according to the Wall Street Journal, this latest ForceShares digital slot machine may have skated through the regulatory process without catching the attention of SEC Commissioners because of a clever structuring tweak which resulted in it being presented to regulators as a commodity product rather than a traditional mutual fund or ETF product.
In December 2015, the SEC proposed a rule that would have made it much more difficult for triple-leveraged and triple-leveraged-inverse ETFs to be sold as mutual funds to retail investors. The rule proposal sought to significantly scale back the exposure that mutual funds could have to derivatives, which provide the rocket fuel that allows leveraged funds to generate exponential returns. The rule could have resulted in closures or forced modifications of dozens of leveraged ETFs.
ForceShares’ products wouldn’t have been subject anyway because they aren’t registered under rules that govern traditional mutual and exchange-traded funds. The company’s 4X fund structure instead was presented to regulators as a type of commodity product that doesn’t need to meet the same standard of investor protections that mutual funds must offer, such as oversight by independent boards of directors. That means some large brokerages might not have been willing to recommend ForceShares’ 4X funds to retail investors, out of concern that regulators would find them too complex for mom and pop traders.
ForceShares’ application could have escaped the attention of commissioners before its approval because the SEC staff has the authority to make some decisions on its own. SEC commissioners can move to review those decisions, including the approval of new products.
Perhaps these same SEC Commissioners, who were absent from the first reviews of ForceShares' latest products, took the opportunity to read the "risk factors" section of their Form S-1:
- the Sponsor has no experience operating commodity pools
- the Sponsor is “leanly staffed” and “relies heavily on key personnel to manage trading activities”
- the success of a Fund depends on the ability of the Sponsor to accurately implement its trading strategies, and any failure to do so could subject the Fund to losses.
- the Sponsor may have conflicts of interest, which may cause them to favor their own interests to your detriment…the Sponsor’s principals, officers or employees may trade futures and related contracts for their own accounts.
- the Sponsor has limited capital and may be unable to continue to manage the funds if it sustains continued losses
- the failure or insolvency of the Custodian for a Fund could result in a substantial loss of the Fund’s assets.
- the Funds are not registered investment companies, so you do not have the protections of the 1940 Act.
Who needs trivial things like "experience" or "capital" anyway....