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SEC Approves Quadruple-Leveraged ETFs

Commentary by Nick Allen and Steven Lofchie

The SEC approved a proposed rule change by NYSE Arca, Inc. that will permit the listing and trading of the first exchange-traded funds ("ETFs") that are quadruple-leveraged ("4X ETFs"). ForceShares Daily 4X US Market Futures Long Fund seeks to provide daily returns that are four times the daily return of the S&P 500® Index futures, and ForceShares Daily 4X US Market Futures Short Fund seeks to provide four times the inverse exposure to the daily return of the S&P 500® Index futures (i.e., if S&P 500® Index futures gain (lose) 1%, the Short Fund would lose (gain) 4%).

Prior to this approval, the highest-leveraged ETFs offered three times leveraged (or inverse leveraged) exposure to their benchmarks.

The SEC determined that this proposed rule change is not in violation of the Exchange Act, examined Section 6(b)(5) and Section 11A(a)(1)(C)(iii) in particular, and noted that the rule change will not fail to protect investors or create information asymmetries. Prior to the commencement of trading, the SEC will disseminate an Information Bulletin to ETP holders that highlights the unique risks involved in trading these ETFs.

Commentary

The SEC's approval of these 4X ETFs may reflect a shift in its policy on the use of derivatives by ETFs and other investment companies. Indeed, the SEC's recently proposed Investment Company Act revisions restricting companies' use of derivatives would have precluded 4X ETFs. Even after this approval, however, exchanges' own listing requirements present an additional barrier to index- and equity-linked 4X ETFs making their debut (e.g., NYSE Arca Equities Rule 5.2(j)(6)(A)(d) precluding leveraging returns "by a multiple that exceeds three times the performance of an underlying Reference Asset").

Commentary

That the SEC went ahead with approving this product may reflect a shift in policy from the SEC acting as a gatekeeper shutting out new products that it might deem inappropriately risky, to determining that investors should decide the products in which they invest, subject to appropriate disclosures. The latter policy is consistent with the historical mission of the SEC, which is to allow investors to make investment decisions, subject to appropriate disclosure. Of course, this also ups the ante for broker-dealers and investment advisers not to make sales of unsuitably risky projects to their customers.

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