To find evidence of retail investors' use of highly levered funds, read responses to the Securities and Exchange Commission's (SEC's) proposals on funds' derivatives use.
"Levered ETFs [exchange-traded funds] are a good product to have access too [sic]. Do not interfere with them. As a small investor, I need access to them at times," writes Thomas Fork of Wickenburg, Arizona, one of the earliest repliers. "Stop HFT if you really want to do some good."
Fork is one of scores of retail investors who wrote to the SEC. The target of their anger is a plan to require more derivatives risk management, to ask funds to set aside cash-like assets covering any costs of exiting derivatives positions, and to cap fund leverage at 150% – or 300%, if funds can show derivatives use is risk-reducing.
The SEC has two aims: to protect retail investors in highly levered funds, and to reduce losses in any sell-off of mutual funds. The regulator frets that high fund leverage makes fire sales more likely, as funds sell assets at a loss to meet redemptions, which in more illiquid markets is more likely still.
Industry bodies rail chiefly against the idea of a leverage cap. BlackRock, Fidelity, Vanguard and hedge fund group AQR are more supportive. AQR suggests a higher cap, risk-adjusted to reflect the risks of different derivatives. As the proposals stand, interest rate swaps are treated the same as commodity futures. Yet in AQR's managed futures strategy fund, rates positions are three times less volatile than commodities.
Asset managers are concerned the rules will penalise hedging. The need for derivatives use to reduce risk might incentivise funds to hold riskier securities, they argue. AQR proposes a fund should be able to exceed the 150% cap if its value-at-risk were also capped, at 20% for example.
These adjustments seem reasonable but the SEC is right to recognise the risks of levered funds. The Investment Company Institute, an industry group, found 173 funds, managing $340 billion assets, were more than three-times levered. Two thirds are bond funds. AQR analysed seven of the 10 biggest managed futures mutual funds, and found six were over four-times levered and three were more than eight-times levered.
If the SEC proposes a simple rule, it is denounced for taking a one-size-fits-all approach. If it adds exemptions and caveats, it is derided for being unduly complicated. But the best course of action would be a middle way – a leverage cap, but one that is risk-adjusted.