I am a retail and self-directed investor mainly trading and investing in US listed leverage & inverse ETFs and associated exchange traded options. I am also a finance professional with work experiences in investment advisory on vanilla and structured products, including equities, fixed income, interest rates and currencies, in overseas jurisdictions outside of the US, and hold MBA and CFA qualifications. My opinion is going to centre around leverage & inverse ETFs & options, and regulatory balance between protection and investment democratisation for retail investors.
Firstly, I want to touch on the definition on complex products. In Regulatory Notice 12-03, leverage and inverse ETFs are included as one of the examples of complex products. In my experience, leverage and inverse ETFs are relatively simple to understand that these products replicate daily return by a certain factor (generally 3x to -3x) to the underlying index or portfolio of assets. The only material nuance or complexity in this type of products is that longer term return can deviate from the simple arithmetic return of the underlying assets after leverage/inverse factor due to volatility drag or compounding effect. However, this problem is very often alerted by brokers and discussed online in various social media and websites. Sometimes, these alerts are over-exaggerated based on hypothetical volatility scenarios, like rising or falling over 20% daily consecutively, which are not empirically founded and not ever seen in very distressed periods like the GFC or even the Great Depression. I personally believe retail investors trading these products are generally sufficiently aware of this problem and the overall risks of leverage/inverse ETFs, and these products is not really “complex” practically.
However, a small portion of leverage and inverse ETFs in the market are investing in futures of the underlying index, e.g. VIX and commodities, rather than the spot index, which is not investable. This is also mentioned in the Regulatory Notice 12-03. Prices and returns between spot and future markets can be materially different in daily or even longer periods. In addition, the lack of free historical data on future markets make it difficult for retail investors to back-test a certain strategy. Therefore, I agree future based leverage and inverse ETFs are complex products. (In contrast, leverage and inverse ETFs tracking investable indexes, with plain vanilla index-tracking ETFs available, have lots of free price data for back-testing, and again not complex.)
Secondly, the current multi-level approval system for option trading is a generally reasonable measure, but there can be improvement on the assessment of knowledge. One particular problem I observed is such trading approval is usually based on the client’s declaration of trading experiences. This not necessarily relates to the actual knowledge on more complex option strategies for different reasons. I believe a fair knowledge test with reasonable difficulty is more appropriate to assess a retail investor suitability to trade options. Besides, this principle applies to other structured equities, fixed income or currencies products with optionality, and the level of knowledge required should the same as the complexity of embedded options, say covered call, spreads, short put, etc.
Thirdly, regulators have to strike a balance between protection and investment democratisation to maximise the well-being of retail investors. One thing the US market has been doing significantly better over other developed markets in Europe and Asia is that US has a more open-minded approach to innovation in the securities markets. We have saw many new types of products launched in the public market available to retail investors. It allows retail investors access asset classes and employ strategies which were traditionally limited to institutional investors or high-net-worth (aka rich) investors only, and brings the benefit of diversification and much lower fees and expenses.
On the other hand, regulators of other markets are more and overly conservative to put lots of restrictions on what retail investors can do. While their intention may be good, the results of their regulations end up setting up many entry barriers for issuers, brokers and retail investors. Investment choices are relatively limited to plain vanilla or traditional products, and fees are high. One particularly bad and unfair policy in some jurisdictions is to set a personal net worth threshold, say USD1M, to separate retail and professional investors for availability of complex products. This is completely arbitrary without any connection to investor’s knowledge level and, more importantly, DISCRIMINATORY to ordinary people except the rich. Ultimately, retail investors’ returns are adversely affected by regulations and only incumbent institutional or rich market participants benefit.
US regulators should continue the open-minded and intervention-lite attitudes and think very careful about the negative effects to retail investors for any well-intended measures, rather than blindly copying what other counter-productive regulators are doing.
Chi Sun Chan Comment On Regulatory Notice 22-08
I am a retail and self-directed investor mainly trading and investing in US listed leverage & inverse ETFs and associated exchange traded options. I am also a finance professional with work experiences in investment advisory on vanilla and structured products, including equities, fixed income, interest rates and currencies, in overseas jurisdictions outside of the US, and hold MBA and CFA qualifications. My opinion is going to centre around leverage & inverse ETFs & options, and regulatory balance between protection and investment democratisation for retail investors.
Firstly, I want to touch on the definition on complex products. In Regulatory Notice 12-03, leverage and inverse ETFs are included as one of the examples of complex products. In my experience, leverage and inverse ETFs are relatively simple to understand that these products replicate daily return by a certain factor (generally 3x to -3x) to the underlying index or portfolio of assets. The only material nuance or complexity in this type of products is that longer term return can deviate from the simple arithmetic return of the underlying assets after leverage/inverse factor due to volatility drag or compounding effect. However, this problem is very often alerted by brokers and discussed online in various social media and websites. Sometimes, these alerts are over-exaggerated based on hypothetical volatility scenarios, like rising or falling over 20% daily consecutively, which are not empirically founded and not ever seen in very distressed periods like the GFC or even the Great Depression. I personally believe retail investors trading these products are generally sufficiently aware of this problem and the overall risks of leverage/inverse ETFs, and these products is not really “complex” practically.
However, a small portion of leverage and inverse ETFs in the market are investing in futures of the underlying index, e.g. VIX and commodities, rather than the spot index, which is not investable. This is also mentioned in the Regulatory Notice 12-03. Prices and returns between spot and future markets can be materially different in daily or even longer periods. In addition, the lack of free historical data on future markets make it difficult for retail investors to back-test a certain strategy. Therefore, I agree future based leverage and inverse ETFs are complex products. (In contrast, leverage and inverse ETFs tracking investable indexes, with plain vanilla index-tracking ETFs available, have lots of free price data for back-testing, and again not complex.)
Secondly, the current multi-level approval system for option trading is a generally reasonable measure, but there can be improvement on the assessment of knowledge. One particular problem I observed is such trading approval is usually based on the client’s declaration of trading experiences. This not necessarily relates to the actual knowledge on more complex option strategies for different reasons. I believe a fair knowledge test with reasonable difficulty is more appropriate to assess a retail investor suitability to trade options. Besides, this principle applies to other structured equities, fixed income or currencies products with optionality, and the level of knowledge required should the same as the complexity of embedded options, say covered call, spreads, short put, etc.
Thirdly, regulators have to strike a balance between protection and investment democratisation to maximise the well-being of retail investors. One thing the US market has been doing significantly better over other developed markets in Europe and Asia is that US has a more open-minded approach to innovation in the securities markets. We have saw many new types of products launched in the public market available to retail investors. It allows retail investors access asset classes and employ strategies which were traditionally limited to institutional investors or high-net-worth (aka rich) investors only, and brings the benefit of diversification and much lower fees and expenses.
On the other hand, regulators of other markets are more and overly conservative to put lots of restrictions on what retail investors can do. While their intention may be good, the results of their regulations end up setting up many entry barriers for issuers, brokers and retail investors. Investment choices are relatively limited to plain vanilla or traditional products, and fees are high. One particularly bad and unfair policy in some jurisdictions is to set a personal net worth threshold, say USD1M, to separate retail and professional investors for availability of complex products. This is completely arbitrary without any connection to investor’s knowledge level and, more importantly, DISCRIMINATORY to ordinary people except the rich. Ultimately, retail investors’ returns are adversely affected by regulations and only incumbent institutional or rich market participants benefit.
US regulators should continue the open-minded and intervention-lite attitudes and think very careful about the negative effects to retail investors for any well-intended measures, rather than blindly copying what other counter-productive regulators are doing.