What is Regulatory Risk for Inverse ETFs?

Regulatory risk for inverse exchange traded funds remains a serious concern. Since inverse ETFs are relatively new, there’s not a lot of data for precedent to be set. The first generation of inverse ETFs were DOG and SH which came about in 2007, less than a decade ago. But today’s inverse ETFs are much more complex than those, with triple leveraged and inverse exchange traded funds in the mix. There is a risk that inverse ETFs, especially leveraged ones, could come under scrutiny by regulators for a variety of reasons. Specifically, regulators are looking at triple leveraged, 3x ETFs. The SEC already issued a warning to retail investors on these use of leveraged and inverse ETFs for their use of derivatives back in 2009.

When a severe market correction or crisis occurs, regulators often look to point fingers and inverse ETFs could be an easy target. We could envision them being blamed for increases in volatility as well. This risk would probably be associated with all leveraged inverse ETFs not just inverse ones. Past examples of this include short-selling bans in U.S. markets in the midst of severe market sell-offs. Extreme examples have been reported in the wake of China’s stock market crash, as some short-sellers in China have even been jailed for destabilizing the markets. Regulatory changes could also affect the counterparties of inverse ETFs which essentially are the ‘holdings’ of the fund.

Inverse ETFs issuers may also be accused of allowing investors to skirt Regulation T margin requirements. The use of inverse ETFs would be curtailed in a large way with increased regulation. Eligibility for certain ETF investors could change as well as their inclusion in certain types of retirement accounts. Brokers may be required to have more collateral or inverse ETF investors may have to be accredited in the future (especially with leveraged inverse ETFs). Only time will tell, but as with any financial sector, regulation is something that needs to be considered.

Other Inverse ETF risks include: