On December 8, Better Markets’ Legal Counsel Scott Farnin took part in an SEC Investor Advisory Committee panel discussion of single stock ETFs. The panel focused on the recent rise of single-stock ETFs, which give investors leveraged returns to the daily returns of specific stocks. Scott explained that single-stock ETFs represent the unnecessary introduction of leverage into our capital markets and pose unique risks for investors.
His full remarks can be found below.
SEC Investor Advisory Committee Panel Presentation Re Single-Stock ETFs
Thank you, Andrew. I would be remiss if I didn’t start by thanking the members of the Investor Advisory Committee first and foremost for not only having this important conversation today, but also for their service on this body, which I believe serves an important function not only to the agency, but to the general public as well.
The SEC finalized Rule 6c-11 in 2019 to “modernize the regulatory framework for ETFs to reflect our more than two decades of experience with these investment products.” The rule helped to usher in a process where ETF sponsors can list ETFs on exchanges and make them available to investors on an expediated basis without the burdens of seeking SEC approval. But, in combination with the ill-advised 2020 rule on Use of Derivatives by Registered Investment Companies and Business Development Companies, Rule 6c-11 was expanded and opened the door for more complex, leveraged and inverse ETFs-in-name only financial products to evade SEC scrutiny as well. This included leveraged and inverse single-stock ETFs, which the SEC had little to no experience with compared to the two decades experience it had with traditional ETFs.
In fact, in the 2019 Rule 6c-11 final rule the SEC stated “leveraged and inverse ETFs are complex products that serve a markedly different investment purpose than most other ETFs.” I would take that a step further and say that allowing complex, leveraged and inverse ETFs that hold swaps, futures contracts, and other derivative instruments to utilize the same listing process as traditional, well diversified ETFs is a policy mistake to the detriment of investors.
In my opinion, single-stock ETFs and other complex, leveraged and inverse ETFs represent the unnecessary introduction of leverage into our capital markets that do not facilitate one of the SEC’s primary missives of facilitating capital formation. And due to the unique risks these leveraged and inverse products pose to investors, which are well-documented by representatives of the SEC throughout the past decade, including:
- a SEC and FINRA investor alert in 2009,
- a Joint statement by former Chair Clayton and the heads of various divisions of the agency in 2020,
- the Investor Advocate,
- current and former Commissioners,
- Chair Gensler,
- as well as stated in various rulemakings –
I would argue that making the Rule 6c-11 process available to these complex products, including single stock ETFs is not in the public interest and does not contribute to the protection of investors as our securities laws mandate.
These risks include the fact that these products have a daily reset which can significantly affect the returns an investor may expect to receive from these products if held for longer than a couple of days. Consider this real-world example noted in the 2009 SEC Investor Alert, “[b]etween December 1, 2008 and April 30, 2009 an ETF seeking to deliver three times the daily return of a certain index fell 53%, while the underlying index actually gained around 8%. An ETF seeking to deliver three times the inverse of the index’s daily return declined by 90 percent over the same period.” Think about that. The Index gains 8%, so you may expect the return of the 3x leveraged index to return close to 24% (which is 3x the return of the index). But, not only does it not gain by 3x, but it actually declines by 53% And the 3x Inverse ETF product declines by 90%
There is counterparty risk due to the financially engineered derivative products these ETFs hold (one need only look at the results of the exchange traded notes that had counterparty risk to Lehman Brothers in 2008 to see how that turned out). And there’s the fact these products are some of the most volatile products in the global markets. A July tweet from Eric Balchunas, an ETF Analyst for Bloomberg, that said quote “the most volatile Exchange Traded Product in the world is LeverageShares -3x Coinbase which has 6 million daily standard deviation of 338%, which is about 13x that of the S&P500. Here’s a look at the top 20. Most are single stock Exchange Traded Products. These things should come with a Xanax.” Additionally, these products also have much higher fees – I’ve seen as high as 1.15% for these products.
This is why, at a minimum, I believe all leveraged and inverse products, including single-stock ETFs, should be excluded from Rule 6c-11, as the 2019 Final Rule had done before being subsequently amended. Alternatively, the SEC may be able to use its authority under the Exchange Act to impose requirements on the exchanges themselves prior to listing these complex products on their exchanges.
Either way, it would be a mistake to continue to allow these complex products to take advantage of Rule 6c-11 and a fast-track to listing without additional regulatory scrutiny, believe the SEC when they say these products serve markedly different purposes than traditional ETFs.
Once these products are listed on an exchange, however; retail investors have varying degrees of access them. And I think that it makes sense to focus for a bit on the avenues retail investors use to access these products. In part due to the long list of warnings and alerts issued by representatives of the SEC, and the fact that it is difficult to reconcile the offering of these products with an investment adviser’s fiduciary duty, many investment advisers and broker-dealers restrict access to these products for their retail customers.
For example, earlier this week I placed money into two brokerage accounts to see how easy it would be to purchase a single-stock ETF product. The first brokerage employs thousands of registered investment advisers and has a very long history offering brokerage services to customers. While I could look up the single-stock ETF I was trying to purchase and view its chart, the brokerage would ultimately not let me purchase the product and said they do not make it available to customers. The second brokerage was a far newer company and as far as I am aware does not have any registered investment advisers on staff. On their platform, I was able to purchase the single-stock ETF, no questions asked.
The reason I bring this up is because it highlights the various degrees of treatment for these products by broker-dealers in the absence of SEC regulation on sales practices. On the one hand, one broker-dealer restricts any and all access to the product, while the other offers it with no due diligence or questions asked about their customer’s ability to understand the risks involved with owning the product. I would argue this is not good for the markets or investors.
This discrepancy can occur in the market because the 2020 rule issued by the SEC on the use of derivatives by registered investment companies failed to adopt proposed sales practice rules on leveraged and inverse funds akin to other complex products due to push back by industry. This was a missed opportunity.
At a minimum, there should be sales practice rules and customer due diligence requirements in place to govern the sale of these complex products to retail investors. This would require broker-dealers and investment advisers to exercise due diligence on retail investors before approving their accounts to invest in leveraged/inverse investment vehicles. While we could certainly have a debate about the level of due diligence many of these broker-dealers currently use for other complex products, say options trading as an example, it is at least another affirmative step both the broker-dealer and the retail investor have to take for them to buy and sell these often misunderstood products.
Only after eliminating the fast-track process for leveraged and inverse ETFs, including single stock ETFs and after a sales practices and due diligence framework is established should additional disclosures be contemplated. For starters, most single-stock ETFs currently include the term “Daily” in their name, but not all leveraged/inverse products with daily resets include this term, which I believe is a helpful signal to investors that these products are meant for daily trading and have resets which can affect returns.
Additionally, while I think it may be a less significant action, I think it is also worth considering whether or not these type of products should be able to use the term “ETF” in their name due to how markedly different they are from traditional, well-diversified ETFs that investors are have experience with.
Finally, I believe it would be beneficial for these products to include in their prospectus not only the historical returns of the fund as they do, but also a comparison of the historical returns of the benchmark index or stock. For example, a 1.5x single-stock ETF for “Company ABC” should include a table with the historical return of that particular fund, as well as, the historical return of Company ABC over the same time period. This will further signal to investors to expect a divergence between the returns of the fund with the returns of the underlying index or stock.