5 Things to Know About 5X ETFs

Forget 3x leveraged risk: new 5x single-stock ETFs are now filed. Find out hurdles the funds will need to overcome to launch, and what it means for investors.

Clipped on from https://www.etf.com/sections/news/5-things-know-about-5x-etfs

Dave Nadig, , https://www.etf.com/sections/news/5-things-know-about-5x-etfs

Forget 3x leveraged risk: new 5x single-stock ETFs are now filed. Find out hurdles the funds will need to overcome to launch, and what it means for investors.

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CORX -1.21%

It’s understandable if you missed it, given the pace of the news cycle, but yesterday the folks at VolatilityShares filed for 27 new single-stock ETFs with leverage ranging from 3X to 5x. While I’d take the “under” on whether these products launch without comment, we’re in an interesting time in financial regulation – what with us defunding the regulators (at least during the shutdown) and already having a very, very permissive SEC.

Here are the big issues and thorny bits:

1: This Ain’t New

ETF issuers have been trying to up the juice on ETFs for a long time (and we’ve already seen a rash of new 3X filings this month), but the current wave is definitely a different animal. The closest we’ve come to just pure 5x filings to my recollection were the ForceShares filings in 2017, which were slated to provide 4X exposure and were even initially approved by the SEC before that approval was rescinded in a highly unusual move.  VelocityShares (part of Janus), briefly had trading 4X Exchange Traded Notes on various currencies starting in 2017, but the bank behind those notes, Citi, shuttered them in a hurry in 2020.

5X levered products already trade in other markets — notably in Europe where funds like LeverageShares “5SPY” see a little activity, but not the kind we’d probably expect from American degen traders should these launch locally.

2: There Aren’t Really Rules About Leverage

The initial reaction on Twitter when the filings came out was pretty understandable:

SEC Rule 18f-4 was adopted almost exactly 5 years ago to provide some guardrails on what was already an increasing use of swaps, options and futures inside otherwise pretty standard 1940 Act mutual funds and ETFs.  The release discussing the rule is itself over 400 pages (some of us have sleep issues). When it was passed, the few existing 3X funds we have trading (like the ProShares “Ultra” series) were grandfathered in but everyone else was assumed to get stuck at 2X because of how funds would be “tested” for leverage: Value-at-Risk - a wonky calculation that says “with X% confidence, we won’t lose Y% of our money over Z days.”

The way this is used in practice is that a new employee otherwise not required – a “Derivatives Risk Manager” on whom most of 18f-4 relies – calculates the 99% confident amount that the fund might lose over 20 days, and divides that by how much a benchmark might lose over 20 days. So for example, right now the S&P’s 99%, 20-day VAR is around 8.6%. Said even more simply, the VAR calc for the S&P says “based on history, 99 times out of 100, you wouldn’t lose more than 8.6% of your money over the next 20 trading sessions.”

The actual hard rule here is the risk manager has to calculate this for the ETF, divide by a benchmark, and not be over 200%, or face a lot of annoying paperwork to get back in compliance. Sounds reasonable right?

3: It’s Not Impossible – Just… Creative.

Like most things in the corners of the ETF market, this all comes down to the funds’ boards. The board has to hire and fire this new “Derivatives Risk Manager” and has very specific vetting, documentation and monitoring requirements. The key loophole here (I suspect, I have had no direct visible evidence yet), is the definition of the “benchmark” against which the DRM will make this calculation. Because there’s a really big difference between how the derivatives rule the industry worked on was written, and how the one that was implemented is written. This, from Ropes & Gray, summarizes it well:

What that means in english is that you can take a fund, say, the 5X Palantir version, remove the derivatives, and use what’s left to make the benchmark VaR calculation. So, if we take a look at say how VolatilityShares runs their 2X Corn ETF (CORX), you find this portfolio:

Which, if you’re paying attention, contains just cash, and derivatives. Remove the derivatives, and you’re “VaR” calculation is now cash. This is actually a problem, because the VaR is relative to this benchmark, and cash has a VaR that’s generally close enough to zero to not matter. The trick is – probably – getting that cash counted as a derivative, leaving only something super volatile and non-derivative left to be the “benchmark.”

Which is why, in the LeverageShares filing, they explain that they can “treat the reverse repurchase agreement transactions as derivative transactions for purposes of Rule 18f-4 under the 1940 Act, including as applicable, the value-at-risk based limit on leverage risk.”

So how can they possibly get to under a 200% VaR relative their non-derivatives holdings once they’ve reclassified a lot of their “cash” as in fact, “derivatives?” I’m going out on a limb here, but what I would do is leave the only non-derivative holding as another leveraged ETF. (An alternative is they use derivatives that have asymetric payouts, like deep in the money options or call spreads).

4: They Might Sneak Through

If I was making odds here, I suspect that these will be nixed by the SEC staff as soon as they come back to work and clear off their desks. But that’s part of the strategy. Thanks to the ETF Rule (6c11) and recent generic listing standards, as crazy as these filings may seem, they are actually “normal,” and thus, if the SEC doesn’t explicitly kaibash them, they go live in 75 days.

If this shutdown drags on into the end of the year, a whole lotta products are just going to appear without a weather eye, and it will all come down to how conservative (!) VelocityShares’ new Derivatives Risk Manager is (and, to state the obvious, if they didn’t think they had the math at least gameably right, they wouldn’t have bothered filing).

5: Crypto Solved This

The appetite for degenerate leverage among retail traders isn’t ever going to go away, and I’m not so much of a moralist that I think things “shouldn’t exist” simply because I don’t like them. But these types of products - no matter how well run - will have significant issues, from counterparty risks and swap availability to hidden financing costs and extreme closure risks.

All of those were solved by the Crypto-folks years ago in the form of perpetual futures. First proposed by TradFi legend Robert Shiller, perpetual futures are a major feature of crypto markets, and non-existent in traditional ones. At their core, they’re simply futures that settle daily or even hourly, constantly moving funding between the winners and losers on each side of a trade. They’re self-financing based on supply and demand for each side of the trade, and allow for as much leverage as the trading venue wants to allow and manage. They have the exquisite advantage of cutting out several high-fee middlemen and never needing to be rolled.

And we can’t trade them on single stocks in the U.S. Yet. The CFTC is looking into perpetuals, and Robinhood is rattling the cage on the topic. Eventually, these types of ETFs will simply cease to exist as the vastly more efficient “crypto way” of doing things takes hold.

Until then, and I cannot say this strongly enough:

Be very, very careful if these things come to market.

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Dave Nadig President & Director of Research