FINRA To Increase Leveraged ETF Margin Requirements

by on September 2, 2009 | ETFs Mentioned:

In a step apparently intended to calm some of the fury surrounding the sale and use of leveraged ETFs, the Financial Industry Regulatory Authority (FINRA) announced Tuesday that it will raise margin requirements for leveraged ETFs beginning December 1. Regulatory Notice 09-53 states that “in view of the increased volatility of leveraged ETFs compared to their non-leveraged counterparts, FINRA believes higher margin levels are necessary.”

Leveraged ETFs have become tremendously popular among investors over the last year because of their ability to deliver amplified daily returns on popular benchmarks. The controversy over these funds has largely centered on their performance when held for multiple trading sessions in oscillating markets. Due to daily resetting and compounding of returns, the returns on these funds over periods longer than a day depend on both the change in the underlying benchmark and its volatility. Some investors who failed to read up on the risks of these funds have been disappointed in their long term results during periods of extreme volatility, prompting complaints about their design and even a few lawsuits. Despite the negative press, leveraged ETFs are actually very efficient products that do an excellent job of accomplishing their plainly stated objectives.

Leveraged ETFs are wildly popular among many active traders who use the funds mostly to profit off of short-term market movements. Even longer-term investing in leveraged ETFs, if done in connection with a disciplined rebalancing plan, can be an effective way to increase returns (see our Free Guide to Leveraged ETFs for a more thorough explanation).

Currently, the margin requirement for any long ETF is 25% of the market value, and 30% for any short ETF. Effective December 1, these margin requirements will increase by a percentage commensurate with the leverage of the ETF. So here’s an example of current margin requirements for leveraged ETFs:

ETF Leverage Price Margin Percentage Required Margin Per Share
ProShares Ultra S&P 500 (SSO) 200% $32.13 25% $32.13 x 25% = $8.03
Direxion Financial Bear 3x Shares (FAZ) 300% $23.17 30% $23.17 x 30% = $6.95

When the new rules take effect, the required margins will double for bull leveraged ETFs and triple for bear leveraged ETFs, meaning the required margins on leveraged ETFs will range from 50% to 90% of the ETF price. The margin requirements for the same funds under the proposed margin requirements would be:

ETF Leverage Price Margin Percentage Required Margin Per Share
ProShares Ultra S&P 500 (SSO) 200% $32.13 50% $32.13 x 50% = $16.07
Direxion Financial Bear 3x Shares (FAZ) 300% $23.17 90% $23.17 x 90% = $20.85

So what does all of this mean to investors? Don Dion thinks the move is the right one, and hopes that the new requirements will have the effect of trimming down the field of investors and acting as a test of suitability.

The vast majority of leveraged ETF investors are sophisticated funds and individuals who thoroughly grasp the complexities and risks of these funds. Unfortunately, it appears that in order to keep the small percentage of investors who are abusing these ETFs, those who are using them as they intended will be penalized. Still, leveraged ETFs will have their fans and loyal users, as these investments will still provide a valuable service to risk-hungry investors.

What is a bit disappointing is that FINRA has elected to make these changes following a period of unprecedented volatility. Because of their daily focus, leveraged ETF returns will generally be less than the return on the underlying index multiplied by the target percentage (generally 200% or 300%). But there’s another side to this coin as well: leveraged ETFs will deliver a return greater than the index return times the target leverage in trending markets (as presented in this example based on the Dow’s recent winning streak). Compounding of daily returns can work both for and against investors over the long-term.

The notice also states that FINRA is increasing the maintenance margin requirements for listed and over-the-counter uncovered options on leveraged ETFs in a similar fashion. At present, the margin requirement is equal to: 100% of the option premium (+) 15% of ETF market value (-) any out-of-money amount.

Disclosure: No positions at time of writing.