Statement on the Final Rule on Funds' Use of Derivatives
Oct. 28, 2020
Today, the Commission adopts a long-awaited framework governing funds’ use of derivatives.[1] The use of derivatives often involves leverage because it enables a fund to magnify its gains or losses relative to the fund’s investment while also exposing the fund to the potential for future payment obligations in certain circumstances. Despite the substantial increase in funds’ use of derivatives over the past several decades, the regulatory framework has been piecemeal at best, composed primarily of a patchwork of sometimes inconsistent guidance and no-action letters. As I said at the time of proposal, a comprehensive rulemaking is needed to establish a systematic approach that more meaningfully limits fund risk-taking,[2] and I appreciate the efforts of the Staff in the Division of Investment Management and the Division of Economic and Risk Analysis.[3]
I supported this rule at the proposal stage. While it was not the rule that I would have written, it nevertheless represented a reasonable framework and approach for governing funds’ use of derivatives and protecting retail investors with respect to leveraged and inverse ETFs.[4]
The final rule, however, abandons much of what made it a reasonable, balanced approach, one that garnered a 5-0 vote just last year. Risk limits designed to place sensible boundaries around speculative investing have now been converted to outer bounds calibrated specifically to ensure that they will have no impact on funds’ existing practices. Moreover, changes in the rule allow funds to tinker with or manipulate those outer bounds, further undermining the notion that the rule imposes meaningful, extrinsic limits. Also, having greatly expanded the permissible leverage risk a fund may undertake, the final rule then drops important disclosures from the proposal about those very risks. And finally, the Commission entirely drops the proposed sales practice rules related to leveraged and inverse ETFs that were designed to protect investors from, and educate them about, well-documented risks involving these investments.
Increasing Risk and Reducing Transparency
For most funds, the final rule doubles the amount of leverage risk that the Commission proposed to permit—an outcome that is simply impossible to square with the limits in Section 18 of the Investment Company Act.[5] Commenters on the proposal provided the Commission with a great deal of feedback about the proposed risk limits, and it was clear that certain types of funds—especially actively-managed fixed-income funds—might experience difficulties in complying with those limits.[6] Importantly, those difficulties are not the result of such funds being high-risk in absolute terms; rather, the challenges were most acute with relatively-low risk funds in which the risk varied significantly from their respective benchmarks for reasons other than leverage.[7]
In response to this concern, the Commission inexplicably doubles the risk limit for all funds, a solution much too broad for the narrow problem presented. This means that even those funds with a benchmark that is an appropriate yardstick are permitted to take on twice the amount of leverage risk the Commission proposed at the outset.[8] This undermines the rule’s purported basis in the statute and increases the potential for funds to engage in more speculative strategies that put the investments of middle class savers and retirees at risk.
Importantly, however, even these greatly expanded risk limits can now be manipulated because changes in the final rule will enable a fund to control its own limit by permitting leverage to be measured against a parameter that the fund itself controls. In setting a fund’s risk limit, the Commission proposed to require funds to compare their risk to a “designated reference index” which could not be administered by, or created at the request of, any affiliate of the fund.[9] This approach would operate to constrain a fund’s leverage risk based on an external measure that the fund does not control.[10] Changes in today’s adopting release, however, will permit a fund to compare its risk to its own securities portfolio, which is effectively all of its non-derivative investments, and the fund’s risk limit will be 200% of that amount.[11]
Thus, a fund can simply change its own derivative risk limits by making changes in its non-derivatives portfolio.[12] This could trigger an entirely perverse incentive for a fund that is approaching or has exceeded its derivative risk limit to actually increase risk in its securities portfolio rather than reduce risk from derivatives in order to come into compliance. This was a central reason the Commission rejected this approach in the proposal, stating that a “VaR [value at risk] test based on a fund’s ‘securities VaR’ would provide an incentive for some funds to invest in volatile, riskier securities that would increase the fund’s ‘securities VaR,’ thereby reducing the test’s effectiveness at limiting fund leverage risk. As a result, investors in these funds would be less protected from leverage related risks compared to the proposed rule.”[13] Today’s final rule now embraces that misincentive.
What’s more, if we are going to allow funds to take on greater leverage risk, we should at a minimum ensure fulsome disclosures that would allow investors and the public to understand and evaluate that risk. Instead, the final rule eliminates much of the disclosure that was proposed, purportedly to reduce the likelihood for unsophisticated investors to misinterpret the information.[14] The final rule’s framework relies almost exclusively on VaR as a measure of and to limit a fund’s leverage risk, so one would reasonably expect that information about a fund’s VaR, including how it changes over time or fluctuates in varying market conditions, would be material information for investors.
But the final rule today removes a significant amount of proposed disclosure around a fund’s VaR, concluding that it may confuse investors, so it’s best they not have access to it.[15] These potentially confused investors are the same ones for whom we now decline to implement sales practice rules, relying instead on their ability to fend for themselves in understanding leveraged and inverse ETFs—products that often confuse even financial professionals. It’s hard to reconcile this incongruity.
Leveraged and Inverse ETFs: Perpetuating the Status Quo
Lastly, I’m deeply disappointed in the failure to advance the proposed sales practice rules, which were designed to address the very real investor harms arising from unsuitable purchases and sales of leveraged and inverse ETFs. This was a central reason for my support of the proposal, and it reflected a genuine focus and concern for protecting retail investors. That’s because, as explained in the proposal, and as experience has shown, retail investors (and even investment professionals) often do not understand the risks involved in holding leveraged and inverse ETFs for periods exceeding the fund’s relevant time horizon.
As the proposal explained, the effects of portfolio rebalancing and compounding in these products can cause a fund’s returns to vary substantially from the performance of the underlying index, especially over periods of time that exceed the fund’s investment time horizon, which is typically one day.[16] Investors holding shares of these funds over a longer period of time may suffer large and unexpected losses or returns that otherwise substantially deviate from what they reasonably anticipated.[17]
The Commission’s concern about leveraged and inverse ETFs is not academic or theoretical. Numerous enforcement cases, both at the Commission and FINRA, have shown that even investment professionals often lack a basic understanding of these complex products.[18] The problem is even more pronounced in self-directed brokerages, where investors do not currently have the benefit of an intermediary to help them understand and evaluate the risks.[19]
Today, the Commission pulls this important protection out of the final rule, pointing to what it describes as “unique challenges” and attempting to justify inaction, at least in part, by suggesting that the proposed sales practice rules might have been under-inclusive.[20] Indeed, other types of complex products not addressed by the proposed rules are known to cause similar harm to unsophisticated retail investors. That view is confirmed in the statement that the Chairman and Division directors issued this morning,[21] but that does not justify or explain why we decline to act now to protect retail investors in leveraged and inverse ETFs, given that the Commission had already preliminarily concluded in its proposal that these protections are needed. The fact that other products present similar dangers should not deter us from addressing the harm to retirees, middle class savers, and other retail investors that is presently and squarely before us.[22]
Conclusion
Unfortunately, this rule did not live up to the promise of the proposal. In fact, it underwent a substantial overhaul—increasing risk, reducing transparency around that risk, and dropping basic sales practice rules for extremely complex products—all to the detriment of retail investors. As a result, I must respectfully dissent.
[1] See Use of Derivatives by Registered Investment Companies and Business Development Companies, Investment Company Act Release No. IC-34084 (Nov. 2, 2020) (“Derivatives Adopting Release”).
[2] See Statement on Proposed Rules on Funds’ Use of Derivatives, Commissioner Robert J. Jackson, Jr. and Commissioner Allison Herren Lee (Nov. 26, 2019).
[3] In particular, I would like to thank the following members of the staff for their efforts on today’s rulemaking: from the Division of Investment Management: Director Dalia Blass, Sarah ten Siethoff, Brian McLaughlin Johnson, Thoreau Bartmann, Amanda Wagner, Blair Burnett, Joel Cavanaugh, Mykaila DeLesDernier, John Lee, Amy Miller, Tim Husson, Tim Dulaney, Ned Rubenstein, Penelope Saltzman, Dennis Sullivan, and Jacquelyn Rivas; from the Division of Economic and Risk Analysis: Chyhe Becker, Malou Huth, Hari Phatak, Alex Schiller, Christian Jauregui, Mi Wu, and Adam Large; and from the Office of the General Counsel: Meridith Mitchell, Natalie Shioji, Cathy Ahn, Bob Bagnall, William (Brooks) Shirey, and Emily Parise.
[4] See Use of Derivatives by Registered Investment Companies and Business Development Companies; Required Due Diligence by Broker-Dealers and Registered Investment Advisers Regarding Retail Customers’ Transactions in Certain Leveraged/Inverse Investment Vehicles, Investment Company Act Release No. 33704 (Nov. 25, 2019) (“Derivatives Proposing Release”). The proposal’s 150% relative VaR limit was modeled on the asset coverage requirements in Section 18 of the Investment Company Act. Section 18 is designed to address: (1) excessive borrowing and the issuance of excessive amounts of senior securities by funds when these activities increase unduly the speculative character of funds’ junior securities; (2) funds operating without adequate assets and reserves; and (3) potential abuse of the purchasers of senior securities. See Derivatives Adopting Release, supra note 1, at 17. To that end, Section 18 limits the ability of open and closed-end funds to issue senior securities (for example, through bank borrowings) by imposing a general requirement to maintain 300% asset coverage. This means that a fund’s borrowings or other senior securities cannot account for more than 1/3 of its total assets. For instance, a fund with $100 in net assets would be limited to borrowing a maximum of $50. The resulting $150 in total assets (including borrowings) would provide for 300% asset coverage of the borrowed amount. At proposal, the Commission explicitly linked the relative VaR limit to the requirements of Section 18: “In proposing a 150% limit, we first considered the extent to which a fund could borrow in compliance with the requirements of section 18. For example, a mutual fund with $100 in assets and no liabilities or senior securities outstanding could borrow an additional $50 from a bank. With the additional $50 in bank borrowings, the mutual fund could invest $150 in securities based on $100 of net assets. This fund’s VaR would be approximately 150% of the VaR of the fund’s designated reference index. The proposed 150% limit would therefore effectively limit a fund’s leverage risk related to derivatives transactions similar to the way that section 18 limits a registered open- or closed-end fund’s ability to borrow from a bank (or issue other senior securities representing indebtedness for registered closed-end funds) subject to section 18’s 300% asset coverage requirement.” See Derivatives Proposing Release, supra note 4, at 109. There is no analogous support in the Investment Company Act for the 200% relative VaR limit included in today’s adopting release.
[5] Under the proposal, a fund’s VaR would have been limited to 150% of the VaR of an unleveraged reference index, which reflects the markets and asset classes in which the fund invests. See Derivatives Proposing Release, supra note 4, at 109-112. Assuming that the index is a fair approximation of the fund’s investments, one would expect the VaR of the fund’s non-derivatives portfolio to be about 100% of (or equal to) the VaR of the index. For the average fund, this means that leverage risk accounts for only about 50% of the proposed 150% limit. For example, assume that both a fund (excluding derivatives) and its reference index have a VaR of 10%. Under the proposal, the fund’s relative VaR limit would have been 150% of the VaR of the reference index, or 15%. In this example, 10% of the fund’s permissible 15% VaR is attributable to its non-derivative investments, while the remaining 5% is attributable to leverage or derivatives risk. In today’s adopting release, however, the Commission increases the limit on a fund’s relative VaR to 200% of the risk of an unleveraged reference index. See Derivatives Adopting Release, supra note 1, at 124-130. Using the example above, the fund would now have a relative VaR limit of 200% of the VaR of the reference index, or 20%. In this example, 10% of the fund’s permissible 20% VaR remains attributable to its non-derivative investments, while the remaining 10% is attributable to leverage or derivatives risk. By increasing the relative VaR limit from 150% to 200%, the amount of permissible leverage risk for a typical fund (assuming the designated reference index is a reasonable approximation of the fund’s non-derivatives risk) is double what it was under the proposal, 10% instead of 5%.
[6] See Derivatives Adopting Release, supra note 1, at 125-126.
[7] See id. (“These commenters stated that this modification would be appropriate to address factors other than a fund’s use of derivatives that could cause a fund’s VaR to exceed the VaR of a designated index. For example, some commenters stated that a fund’s security selection will influence a fund’s relative VaR calculation. Commenters stated that the proposed VaR test could be particularly restrictive for actively-managed fixed-income funds. These commenters stated that an actively-managed fixed-income fund will have an expected amount of tracking error against a low-volatility benchmark based on the fund’s security selection and concentration levels. Differences between a fund’s portfolio and its reference portfolio—rather than leveraging with derivatives—could cause a fund’s VaR to exceed the VaR of its designated reference portfolio.”).
[8] See supra note 5.
[9] See Derivatives Proposing Release, supra note 4, at 98-105.
[10] Id. To avoid the potential for an adviser to manipulate an index’s components, the Commission specifically required that the index not be administered by, or created at the request of, a fund or its investment adviser. Id. at 101. This condition was designed to ensure “that the indexes permissible under the proposed rule would be less likely to be designed with the intent of permitting a fund to incur additional leverage-related risk.” Id.
[11] See Derivatives Adopting Release, supra note 1, at 121-124 (discussing the addition of a fund’s “securities portfolio” as a permissible alternative to a designated reference index). Rule 18f-4 defines a fund’s “securities portfolio” as “the fund’s portfolio of securities and other investments, excluding any derivatives transactions, that is approved by the derivatives risk manager for purposes of the relative VaR test, provided that the fund’s securities portfolio reflects the markets or asset classes in which the fund invests.” Id. at 427.
[12] The release discusses certain requirements relating to a fund’s use of its securities portfolio as an alternative to a designated reference index. See Derivatives Adopting Release, supra note 1, at 122-123. In general, the requirements are similar to those that apply to the selection of a designated reference index: it must be approved by the fund’s derivatives risk manager for use as part of the relative VaR test, and it must reflect the markets and asset classes in which the fund invests. Id. While the second condition acts as a constraint on a fund investing in securities that are wildly out of sync with its general strategy solely for the purpose of increasing its respective VaR limit, it presents less of a barrier to similar conduct in the context of, for example, an actively managed equities fund. If such a fund is approaching or has exceeded its 200% relative VaR limit, the fund’s adviser could conceivably adjust its securities portfolio to take on more risk, producing a corresponding (but doubled) increase in its relative VaR limit. Assume, for example, a fund with a “securities portfolio” VaR of 10%, and a resulting relative VaR limit of 20%. If, as a result of its use of derivatives, the fund approaches its 20% relative VaR limit, changes in the adopting release introduce the possibility that the adviser could simply adjust its “securities portfolio” such that the VaR of the fund’s securities portfolio is 11%, thus increasing the fund’s relative VaR limit to 22%.
[13] See Derivatives Proposing Release, supra note 4, at 316.
[14] See Derivatives Adopting Release, supra note 1, at 225-226 (“While we recognize that this information could help some market participants assess the effect of derivatives use on funds that have similar strategies but different VaRs, many investors may not have the expertise or experience to understand VaR and could misinterpret VaR figures, especially when comparing funds.”), 227-228 (explaining that the Commission will no longer require public report of backtesting exceptions in response to comments that claimed investors might “misunderstand or ascribe inappropriate significance to backtesting exceptions” and that reporting of backtesting exceptions “might confuse investors about the risks associated with a fund’s use of derivatives”). The Commission offers no explanation or rationale regarding its elimination of the public disclosure of a fund’s highest VaR during the reporting period. See id. at 226-227. While the Commission explains that the staff and Commission will still be able to evaluate a fund’s compliance with the rule by reviewing fund’s median VaR reporting and any relevant Form N-RN filings, neither of those will be available to the public. Id. The adopting release simply ignores any benefit that might accrue to investors from transparency about when and how high a fund’s VaR spikes in a given reporting period and over time.
[15] The proposal would have required a fund to publicly disclose certain information about its VaR in periodic filings with the Commission, including: 1) the fund’s highest VaR during the reporting period; 2) the fund’s median VaR during the reporting period; and 3) the number of times in the reporting period that the fund’s VaR was inaccurate. See Derivatives Proposing Release, supra note 4, at 208-212. Additionally, a fund would have been required to disclose its gross notional derivatives exposure. See id. at 208-209.
[16] See Derivatives Proposing Release, supra note 4, at 178 (“Leveraged/inverse funds and certain commodity pools following the same strategy also present unique considerations because they rebalance their portfolios on a daily (or other predetermined) basis in order to maintain a constant leverage ratio. This reset, and the effects of compounding, can result in performance over longer holding periods that differs significantly from the leveraged or inverse performance of the underlying reference index over those longer holding periods. This effect can be more pronounced in volatile markets. As a result, buy-and-hold investors in a leveraged/inverse fund who have an intermediate or long-term time horizon—and who may not evaluate their portfolios frequently—may experience large and unexpected losses or otherwise experience returns that are different from what they anticipated.”).
[17] Id.
[18] See, e.g., SEC Charges Wells Fargo In Connection With Investment Recommendation Practices, Press Release 2020-43 (Feb. 27, 2020), https://www.sec.gov/news/press-release/2020-43 (The order finds that some Wells Fargo brokers and advisers did not fully understand the risk of losses these complex products posed when held long term. As a result, certain Wells Fargo investment advisers and registered representatives made unsuitable recommendations to certain clients to buy and hold single-inverse ETFs for months or years. According to the order, a number of these clients were senior citizens and retirees who had limited incomes and net worth, and conservative or moderate risk tolerances.”); In the Matter of Morgan Wilshire Securities Inc., Exchange Act Release No. 89979 (Sept. 24, 2020), https://www.sec.gov/litigation/admin/2020/34-89979.pdf (“During the relevant period, certain Morgan Wilshire registered representatives recommended that a number of their retail customers buy inverse ETFs without regard to holding periods. Based on these recommendations, Morgan Wilshire customers purchased and held these inverse ETFs for longer than a single day, and in many cases, months, or years. Those registered representatives did not adequately understand all of the features and risks of inverse ETFs.”). The inability of even many financial professionals to understand the features and risks of leveraged and inverse ETFs exposes the serious weaknesses in the Commission’s continued reliance on disclosure to protect retail investors purchasing such products through self-directed brokerage accounts from those risks.
[19] See Derivatives Adopting Release, supra note 1, at 208 (“We recognize that while Regulation Best Interest applies to all exchange-traded products, including products that the proposed sales practices rules did not cover, it applies only where a broker-dealer recommends a transaction or an investment strategy involving securities to a retail customer.”).
[20] See id. at 202-209.
[21] See Joint Statement Regarding Complex Financial Products and Retail Investors, Chairman Jay Clayton, Dalia Blass, William Hinman, and Brett Redfearn (Oct. 28, 2020), https://www.sec.gov/news/public-statement/clayton-blass-hinman-redfearn-complex-financial-products-2020-10-28 (“We believe that these leveraged/inverse products and other complex products may present investor protection issues—particularly for retail investors who may not fully appreciate the particular characteristics or risks of such investments, including the risks that holding such products may pose to their investment goals.”).
[22] What’s more, existing 3x ETFs will continue to operate, under what is now effectively a regulatory duopoly, and sponsors of 2x ETFs can now rely on last year’s ETF Rule to create even more leveraged and inverse funds, despite the fact that the Commission has failed to address the concerns that kept those funds out of the rule to begin with.