6

I'm very interested in geared ETFs.

It appears that the highest available gear ratio is 3x the underlying security (or index).

Is this due to regulation, mathematics, or market demand?

2

After the 2009 collapse, there were calls to regulate levered ETFs and rebuttals against that position.

The reason why is because especially with the 3x Financials, where the underlying lost nearly 50% in two months, the 3x lost approximately 90%, a well-managed decline considering that 0.5^3 is a nearly 90% loss, so it fulfilled its objective to get 3x the geometric return of the underlying. They are not intended to amplify arithmetic returns, so a 50% loss will not wipe the levered fund out, only incompetence.

After those calls for regulation, Direxion called it quits on expanding its offerings which were to include a 10x set of ETFs.

The real risk of a levered ETF is that it may not achieve its goal of geometrically amplifying an underlying's return, thus if one is using a -3x to hedge underlying, a generally effective strategy at reducing volatility, then a long run hedge will break down because a single day's return is ignored the next day since these are daily levered funds. There were plans to offer monthly return so that errors could be corrected, but they were also stopped in their tracks by the calls for regulation.

Here, there is no doubt that just the mere threats of regulation have hurt the little guy's, such as myself, ability to hedge.

  • Yes, the early 2009 issues was a catalyst for halting the existing of more highly leveraged ETFs, if you look at proposals from the CBOE and try to follow up with them in the SEC's Division of Economic and Risk (created in late 2009), you'll hear the same kind of hesitance I described in my answer. Mainly a discretionary feeling that something may be too speculative to approve. – CQM Feb 21 '14 at 20:07
  • @CQM Yes, and the little guy suffers as a result. Kind of like what they're about to do to spreads on small caps. Just another way regulators hurt the little guy and make it too expensive for them to play. – user11865 Feb 22 '14 at 0:35
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    I'm very aware, I frequently ask questions about how to improve the rules in my favor, but people on this site assume I am a narcotrafficking tax fraud conspirator :) funny how that works – CQM Feb 22 '14 at 0:48
  • @CQM Second that feeling. – user11865 Feb 22 '14 at 17:37
3

There is no fundamental reason that you don't find ETF's that proclaim to offer more than 3x leverage in the US capital markets.

Given that it is quite simple to get A LOT more leverage, or for any trader create more than 3x leverage synthetically, there is surely market demand for greater leveraged products.

Mathematically, a 3x leveraged ETF structure will lose all of its value if the underlying asset declines by 33% in one day. So a 4x and a 5x leveraged ETF will be subject to greater shocks making their value drop to zero with smaller percentage moves in the underlying asset, dampening investor and trader confidence in those products, since people will rather fight tooth and nail before actually reading a prospectus.

From a regulatory standpoint, the Securities and Exchange Commission (SEC) and culture in the United States still retain an arbitrary moral weighting drawing a distinction between investing and gambling where there frequently is none. As such the will of the people extends to a regulatory framework that also weighs financial products based on their similarities to gambling. So the SEC will take pause to more and more extreme publicly traded financial vehicles, if they are all introduced at once. The SEC has to be gradually coaxed to approve the latest and greatest "hedging tool for daytraders". Even though the SEC does not officially evaluate the merit of an investment or a financial product, they still have a great degree of discretion in approving what trades.

  • Not really - most of them work on a daily basis (i.e. the return of the ETF on a given day is 3x the return of the underlying). So even a x10 ETF would not go down to 0, unless the underlying does of course or the underlying has a -10% in a single day. – assylias Feb 21 '14 at 19:45
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    @assylias isn't that what I said? regardless I think we conveyed the same message – CQM Feb 21 '14 at 20:03

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