A recent statement by BlackRock Inc (BlackRock) Chief Executive Larry Fink concerning leveraged exchange traded funds (Leveraged ETFs) has provoked a chain reaction from the ETF industry. Fink runs BlackRock, the world’s largest ETF provider. Fink’s statement that structural problems with Leveraged ETFs have the potential to “blow up the whole industry one day” have rattled other ETF providers – none more so than those selling bank loan ETFs. Naturally, sponsors of Leveraged ETFs, a $60 billion market, called the remarks an exaggeration.
As a background, leveraged ETFs use a combination of derivatives instruments and debt to multiply returns on an underlining asset, class of securities, or sector index. The leverage employed is designed to generate 2 to 3 times the return of the underlining assets. Leveraged ETFs can also be used to return the inverse or the opposite result of the return of the benchmark. While regular ETFs can be held for long term trading, Leveraged ETFs are generally designed to be used only for short term trading – sometimes as short as a single day’s holding. The Securities Exchange Commission (SEC) has warned that most Leveraged ETFs reset daily and FINRA has stated that Leveraged ETFs are complex products that are typically not suitable for retail investors. In fact, some brokerage firms simply prohibit the solicitation of these investments to its customers, an explicit recognition that a Leveraged ETF recommendation is unsuitable for virtually everyone.
Despite these dangers, bank loan Leveraged ETFs may be an easy sell to investors. Investors in fixed income instruments are compensated based upon the level of two sources of bond risk – duration risk and credit risk. Duration risk takes into account the length of time and is subject to interest rate changes. Credit risk evaluates the credit quality of the issuer. For example, U.S. Treasury’s have virtually no credit risk and investors are compensated based on the length of the bond. At the other end of the safety spectrum are low rated floating-rate debt – what bank loan Leveraged ETFs invest in. These funds are supposed to reset every 90 days in order to get exposure to the credit side but not take on much duration risk.
However, in a financial panic the liquidity of these funds could dry up and they may not perform as expected. In his statement Fink was speaking at a Deutsche Bank conference in New York and drew parallels between Leveraged ETFs and the two Bear Stearns hedge funds that collapsed in the panic of 2007. Fink was of the position that an inherently illiquid asset does not become more liquid merely because it is wrapped up in a Leveraged ETF fund. In theory, a systemic risk could emerge from packaging illiquid securities, such as bank loans, into ETFs. A theoretical shock to the financial markets could cause the value of the Leveraged ETF to decline rapidly triggering a freeze for the underlying assets. As the shockwave hits the Leveraged ETF market, investors would scramble to flee the funds only to find that the liquidity promised by ETFs disappears. In this case the investor would then have to make the trade a severe and unexpected discount.
Leveraged ETFs are evidence that even after the financial crisis, Wall Street has been hard at work designing new and complicated products to aim at Main Street investors. The pitch has been that investors “need” to invest beyond traditional stocks and bonds in order to diversify. Many investors are being told to find returns sufficient for retirement in a low interest rate environment. However, some have questioned whether FINRA and the SEC pay enough attention to new financial products entering the market. Regulators, instead of asking whether these products have benefits that outweigh risks to investors and the broader market, often times wait until the financial system is imperiled in some way before common sense reforms take hold.