Stephen Denis Delear Comment On Regulatory Notice 22-08
Stephen Denis Delear
N/A
Direxion put out a request for investors in their products to comment on this proposed action. I figure it would be better to avoid going through their portal. The consensus seems to be that the proposed action, in its details, would ban most investors from purchasing inverse and leveraged funds. These comments apply to exchange traded inverse and leveraged funds, and not similar products that may be illiquid or have redemption restrictions.
These are the thoughts of a small, self-directed investor. My retirement strategy includes FERS and TSP plans. Outside investment is used to supplement the limited options available in TSP. I have additional agency restrictions that forbid investment in the energy sector or with companies with large involvement in public lands. My target horizon is 25 years.
The proposed action would harm small investors by forcing abandonment of indexing when seeking higher returns. According to Bogle, and Malkiel, the average investor is highly unlikely to make stock picks that outperform the market. Higher returns require increasing the risk in a portfolio. Leverage funds increase risk in an understandable and quantifiable manner (albeit one that is not always the exact multiplier stated). A leveraged fund is, likely, no worse of an investment than a car company with a mentally unstable CEO – and may well turn out to be the better choice. Small investors would be harmed by creating a market where searching for a return greater than an index fund required a total abandonment of index based investing.
The proposed action seems to ignore the positive benefits inverse and leveraged funds can have for smaller investors. Both effects can be mimicked by standard tools, short selling and margin, found in most brokerage accounts. Using an ETF structure allows smaller investors to limit losses to no greater than their initial investment.
Shorting creates a, theoretically, unlimited liability – and a corresponding need to babysit the short position. An inverse fund can go to zero, but that’s where the investors losses stop. There are times when it makes sense to short an index, for example shorting bonds is likely a decent idea in the current environment. Lack of access to inverse funds would encourage more traditional short selling, increasing investors exposure to unlimited downside risk and thereby hurting small investors.
Likewise margin creates a number of difficulties. While not exact (leveraged funds reset daily) the effects of a leveraged fund can be mimicked using margin. There are a number of downsides to this. A broker is likely to monopolize the collateral, taking an interest in all the securities in an account. Margin can take quite a large amount of time to manage. A small investor may only have one account, and may hold short term government bonds/bond ETFs, CDs, or other very low risk securities intended to hold funds likely to be needed in the near future (for example using bonds to save for a down payment). Small investors may not want these short term, low risk, holding subject to margin risk. Further, margin trading carries a risk of wiping out the entire account. By contrast, the risk with a leveraged ETF is contained. The ETF might go to zero, but the investors loss is capped at their initial investment. Other securities in the account are not subject to liquidation if the ETF crashes. Small investors would be hurt by the proposed action as it would encourage use of margin, where losses may spill over to other securities.
Somebody may well retort that leveraged funds are advanced financial instruments meant for active trading on a daily basis and that small investors may be inclined to hold the position in the long term. This is not a proper regulatory concern. Individual investment strategies are simply none of your business. If investors decline to engage in a day trading strategy, that is a legitimate investment decision that should not be subject to regulatory review. The a regulator dislikes an investment strategy should not be grounds to declare that those pursuing it do not know what they are doing and that access should be restricted to those most likely to use it “correctly.” If nothing else, the continued subpar performance of hedge funds other private equity vehicles, shows that limiting access to an investment is likely to drive demand for social capital reasons – even if an index fund will give better returns.
Finally the premise of the proposed action is flawed. The fear seems to be that self-directed investors are at greater risk for not going through an advisor. The traditional investment adviser is not a fiduciary. The average investment adviser, indeed the average fund manager, is not beating the market on a risk adjusted basis. A simple review of historical posts by investment advisors on the SeekingAlpha website will find the average quality of advice given by self reported financial advisers is, in retrospect, very low and highly self interested. Small investors would be affirmatively hurt by any move that might encourage the use of advisers who are not charged with acting as a fiduciary.
In closing, I note that the announcement of the proposed action is a complete mess and that this should have been split into multiple actions with clear and concise scope and objectives.
Stephen Denis Delear Comment On Regulatory Notice 22-08
Direxion put out a request for investors in their products to comment on this proposed action. I figure it would be better to avoid going through their portal. The consensus seems to be that the proposed action, in its details, would ban most investors from purchasing inverse and leveraged funds. These comments apply to exchange traded inverse and leveraged funds, and not similar products that may be illiquid or have redemption restrictions.
These are the thoughts of a small, self-directed investor. My retirement strategy includes FERS and TSP plans. Outside investment is used to supplement the limited options available in TSP. I have additional agency restrictions that forbid investment in the energy sector or with companies with large involvement in public lands. My target horizon is 25 years.
The proposed action would harm small investors by forcing abandonment of indexing when seeking higher returns. According to Bogle, and Malkiel, the average investor is highly unlikely to make stock picks that outperform the market. Higher returns require increasing the risk in a portfolio. Leverage funds increase risk in an understandable and quantifiable manner (albeit one that is not always the exact multiplier stated). A leveraged fund is, likely, no worse of an investment than a car company with a mentally unstable CEO – and may well turn out to be the better choice. Small investors would be harmed by creating a market where searching for a return greater than an index fund required a total abandonment of index based investing.
The proposed action seems to ignore the positive benefits inverse and leveraged funds can have for smaller investors. Both effects can be mimicked by standard tools, short selling and margin, found in most brokerage accounts. Using an ETF structure allows smaller investors to limit losses to no greater than their initial investment.
Shorting creates a, theoretically, unlimited liability – and a corresponding need to babysit the short position. An inverse fund can go to zero, but that’s where the investors losses stop. There are times when it makes sense to short an index, for example shorting bonds is likely a decent idea in the current environment. Lack of access to inverse funds would encourage more traditional short selling, increasing investors exposure to unlimited downside risk and thereby hurting small investors.
Likewise margin creates a number of difficulties. While not exact (leveraged funds reset daily) the effects of a leveraged fund can be mimicked using margin. There are a number of downsides to this. A broker is likely to monopolize the collateral, taking an interest in all the securities in an account. Margin can take quite a large amount of time to manage. A small investor may only have one account, and may hold short term government bonds/bond ETFs, CDs, or other very low risk securities intended to hold funds likely to be needed in the near future (for example using bonds to save for a down payment). Small investors may not want these short term, low risk, holding subject to margin risk. Further, margin trading carries a risk of wiping out the entire account. By contrast, the risk with a leveraged ETF is contained. The ETF might go to zero, but the investors loss is capped at their initial investment. Other securities in the account are not subject to liquidation if the ETF crashes. Small investors would be hurt by the proposed action as it would encourage use of margin, where losses may spill over to other securities.
Somebody may well retort that leveraged funds are advanced financial instruments meant for active trading on a daily basis and that small investors may be inclined to hold the position in the long term. This is not a proper regulatory concern. Individual investment strategies are simply none of your business. If investors decline to engage in a day trading strategy, that is a legitimate investment decision that should not be subject to regulatory review. The a regulator dislikes an investment strategy should not be grounds to declare that those pursuing it do not know what they are doing and that access should be restricted to those most likely to use it “correctly.” If nothing else, the continued subpar performance of hedge funds other private equity vehicles, shows that limiting access to an investment is likely to drive demand for social capital reasons – even if an index fund will give better returns.
Finally the premise of the proposed action is flawed. The fear seems to be that self-directed investors are at greater risk for not going through an advisor. The traditional investment adviser is not a fiduciary. The average investment adviser, indeed the average fund manager, is not beating the market on a risk adjusted basis. A simple review of historical posts by investment advisors on the SeekingAlpha website will find the average quality of advice given by self reported financial advisers is, in retrospect, very low and highly self interested. Small investors would be affirmatively hurt by any move that might encourage the use of advisers who are not charged with acting as a fiduciary.
In closing, I note that the announcement of the proposed action is a complete mess and that this should have been split into multiple actions with clear and concise scope and objectives.