Deregulation has been one of the great Trump-administration success stories. So why does the Securities and Exchange Commission want more cumbersome rules that will restrict investor choices? A new 456-page SEC rule restricts the availability of a subset of Exchange Traded Funds (ETFs), specifically those that offer returns that are the inverse or a multiple — double or triple — of a reference index. Inverse funds go up when the market goes down — which has been handy lately. Leveraged funds track their indexes with a multiple of two or three.
These ETFs are popular because they are low-cost, transparent, and well-regulated funds that can be used to reduce risk in a portfolio or to gain exposure to an index with less cash. They are generally straightforward in their names and descriptions, and hardly mislead investors.
Yet Trump-appointed SEC chairman Jay Clayton — along with the two commissioners who are Democrats — has proposed requiring brokers and advisers to “exercise due diligence” before allowing a customer to buy one of these ETFs. At a minimum, the SEC would require the broker or adviser to determine the customer’s investment objectives, time horizon, employment status, estimated income, estimated total net worth, estimated liquid net worth, percent of liquid net worth intended to be invested, and investment experience and knowledge — which the SEC suggests would include years, size, frequency, and types of transactions involving stocks, bonds, commodities, options, and other financial instruments.
But somehow, that exhaustive amount of required information is not necessarily enough. The SEC would not create any bright-line test for brokers and advisers to prove they have complied with the new rule. Instead, they would be required to use a facts-and-circumstances test to show that they have a reasonable basis for believing an investor can understand a leveraged or inverse ETF. The two other Republican SEC commissioners have expressed major concerns about the rule, calling it an “overly paternalistic approach.”
Markets always go up and down. Putting a new legal risk on these kinds of investments will only raise their cost — which surely doesn’t benefit investors — or simply price smaller investors out of the market altogether.
The SEC would allow investors who currently own these products to sell them without these new hurdles. But otherwise, the rule would prohibit even existing accounts from buying or selling the supposedly dangerous products until they meet the extensive new requirements.
Some brokers would likely drop these funds entirely rather than set up the complicated compliance process. This will reduce investors’ choices and could reduce their returns or amplify their risk.
Even worse, the SEC is engaging in this regulatory adventurism with very little evidence that these ETFs present a problem to be solved. There is a theory that some inexperienced investors may misunderstand that daily performance of an index means its performance daily, creating unexpected results or large losses over a longer holding period. Yet the SEC itself acknowledges research showing that the ETFs have an “average implied holding period ranging from 1.18 days to 4.03 days.”
Moreover, it’s not at all clear that it’s irrational for an investor to consider holding these funds for the long term. In fact, it might surprise the SEC commissioners to learn that leveraged ETFs were among the top-performing funds for the entire decade that just concluded. Like all investments, these funds need to be monitored for changing market conditions. But certainly there’s no evidence that government should declare any such strategy presumptively ignorant and use it as the basis for regulation.
Worst of all, though, is the potential for this rule to become a new precedent. If it does, it could open up a Pandora’s Box of new regulatory barriers against the small investor. These ETFs are securities traded on public stock markets, which have never before been subject to investor certification requirements. If a Republican-chaired SEC determines that this narrow class of securities should be available only to investors who can exhaustively document their investment fitness, it is easy to imagine the SEC in future administrations extending these requirements to other asset classes and, perhaps, ultimately to securities markets as a whole.
The SEC should look for ways that to provide small, non-institutional investors a full range of investment products from which to choose. This new regulatory approach would invite further impediments to small investors’ getting the best products they can. Instead, the SEC should make sure that everyone, not just the big boys on Wall Street, can invest and trade as they wish.
Stephen Moore is the chairman and Phil Kerpen is the president of the Committee to Unleash Prosperity.