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SEC’s Proposed Rules Would Take ETFs out of the Hands of Middle-Class Investors

On behalf of the Competitive Enterprise Institute, my colleague John Berlau recently signed a coalition letter encouraging the Securities and Exchange Commission (SEC) to abandon its plans to further regulate certain financial products and impose additional sales-practice rules between broker-dealers and investment advisors and their clients. Going against the Trump administration’s effort to cut red tape, these proposed rules would impose an intrusive and burdensome regulatory regime on financial markets and severely limit the ability of everyday investors to freely purchase or sell some publicly traded securities.

The letter was also signed by representatives of Heritage Action for America, Americans for Tax Reform, FreedomWorks, the Shareholder Advocacy Forum, the National Taxpayers Union, the 60 Plus Association, the Center for Freedom and Prosperity, and the Campaign for Liberty.

Specifically, the SEC re-proposed rule 18f-4 under the Investment Company Act of 1940—a rule that was originally proposed in 2015, but later abandoned, during the Obama administration—and proposed new rule 15l-2 under the Securities Exchange Act of 1934 and new rule 211(h)-1 under the Investment Advisers Act of 1940.

These rules would require broker-dealers to gather a great deal of detailed personal information on their clients, including:

  • Their investment objectives;
  • Employment status;
  • Annual income;
  • Estimated net worth;
  • Estimated liquid net worth;
  • Percentage of the customer’s estimated liquid net worth that he or she intends to invest in leveraged/inverse investment vehicles; and
  • Information about the customer’s investment experience and knowledge regarding leveraged/inverse investment vehicles, options, stocks and bonds, commodities, and other financial instruments.

Once all this information in collected, the broker-dealer then must arbitrarily determine whether or not their client is “capable” of understanding the risks associated with purchasing a certain financial product. If the broker-dealer sees the client as “incapable,” then the client is outright prohibited from purchasing the product. It’s easy to image that many broker-dealers will deem their clients as “incapable” because of the regulatory backlash they could face for allowing them to invest in riskier products.

These rules would especially impact the trade of leveraged or “geared” Exchange Traded Funds (ETFs), which critics claim are often riskier than other “plain vanilla” investment vehicles. However, these leveraged ETFs have been available on the market for over a quarter century and are often chosen by investors, since they can easily earn two or three times more the daily rate of return of less risky products. In addition, investors usually use leveraged ETFs as a short-term investment to speculate on an index or to take advantage of an index’s short-term momentum—so investors rarely hold leveraged ETFs for more than a couple days.  

The SEC Division of Economic and Risk Analysis estimates that the total industry cost for these rules would be a massive $2.4 billion and another $450 million annually. As is the case with other burdensome and expensive regulations, the cost of these rules will be passed on to investors themselves, since broker-dealers and investment advisors will need to recoup the increased cost of doing business.

Before going through with these rules, the SEC should evaluate the impact of the Regulation Best Interest rule it promulgated only a few months ago and see if that addresses its concerns regarding leveraged ETFs.

If the SEC pushes forward with these proposed rules, thousands of Main Street investors will be denied the freedom and opportunity to choose the financial products they think best fit their investment portfolio.

CEI will be filing comments to the rulemaking due March 24, and we urge other interested parties to do so.

For more on the negative impact the rules would have on ordinary investors, read Berlau’s recent Washington Times op-ed.