Leveraged exchange-traded funds may see an uptick in demand during 2017 as the Financial Conduct Authority’s (FCA) crackdown on contracts for difference (CFDs) leads traders towards less aggressive leveraged offerings.
In Europe, ETFs providing up to five times leverage on an underlying asset are available.
A CFD is a tradable instrument that mirrors the movements of the asset underlying it. CFDs currently offer much higher leverage compared to traditional trading with margin requirements beginning as low as just 2%. CFDs are outlawed in the US.
Indicating the gravity of the FCA’s move, the three most high profile providers of these instruments, CMC Markets, IG Group and Plus500 saw their share prices fall 35%, 40% and 28% respectively following the FCA’s proposal for stricter rules for firms selling CFDs.
The FCA is also seeking to better regulate binary bets which allow traders to bet whether the price of a financial instrument will be higher or lower than a fixed threshold at a future point in time.
The tougher regulation may provide a boon for the leveraged ETF market as traders seek alternatives to CFDs. In Europe, ETFs providing up to five times leverage on an underlying asset are available.
Inflows into leveraged and inverse ETFs listed in Europe were $2.4bn this year to the end of November.
Morningstar senior ETF analyst Jose Garcia-Zarate explains these ETFs should still only be used for tactical short-term exposures rather than buy-and-hold investments.
“They are trading instruments to roll out tactical positions with a very short-term horizon,” he told ETF Strategy.
“It’s one thing to think that the equity market is going to go up over the mid to long term; it’s very different to think that it will do so day after day. For the overwhelming majority of investors, a non-leveraged product will be just fine.”
The leveraged ETF market may also see further growth in the US next year as Donald Trump’s anti-regulation stance revives the industry, leading to greater product offerings.
In 2015 the Securities and Exchange Commission (SEC) in the US proposed to ban so-called ‘triple-X funds’ (triple leveraged ETFs) as most investors did not fully understand the high risks involved in the underlying derivatives used to leverage returns.
While they can provide three times the gain of tracking a regular long-only index, they also can bring big losses and are exceptionally risky for retail investors that do not understand them.
However, pro-regulation chair Mary Jo White has announced she will step down in January, shaking up the balance of power at the SEC.
While White could still pass her rule to ban triple-X ETFs in the US before president Obama steps down, it is unlikely.
“This rule was a fait accompli, and now it’s anything but,” Matt Hougan, CEO of Inside ETFs told The Street. “With the resignation of Chair White, things are changing dramatically. The tide is anti-regulatory.”
As such, ETF providers like ProShares and Direxion are reportedly mulling which leveraged funds they could roll out early next year.
The issue is still divisive however with critics worried that the Trump era will roll back regulations imposed over White’s four-year tenure, allow a surge in exotic and risky instruments and result in harm for consumers.
Micah Hauptman, financial-services counsel at the Consumer Federation of America, told The Street: “[…] as we’ve seen time and time again, when you allow market participants to police their own activities, they don’t, and they just do really risky things that harm investors and ultimately expose the financial system to excessive risk.”
Total flows into US-listed leverage and inverse ETFs were $2.1bn from January through November, pushing total assets to $34.7bn, according to Morningstar. It is still a small sector compared to the overall ETF market of more than $3tn.