The Securities and ExchangeCommission has become a punching bag for some critics of market oversight because it wasn't able to uncover Bernie Madoff's investment fraud. But the agency should be applauded for a recent move to limit the leverage retail investors can take on.
This initiative went largely unnoticed amid all the attention given to the recent enactment of the Department of Labor's widely publicized Fiduciary Rule, but it's important. In case you missed the news, SEC chair Mary Jo White announced that the agency was moving ahead with plans to limit the amount of leverage that exchange-traded funds are allowed to employ. The proposed rule would limit the leverage to 1.5 times its net assets.
This is welcome news to all those who wish to encourage true investment over speculation.
Benjamin Graham, the "Father of Financial Analysis" and mentor of Warren Buffett, clearly contrasted speculation and investing in his seminal work, The Intelligent Investor. Graham wrote, "An investment operation is one which, upon thorough analysis, promises safety of principal and an adequate return. Operations not meeting these requirements are speculative." He went on to say that "If you are a speculator, your decision to buy or sell is based upon what you believe about the near-term direction of price."
Unfortunately, today too many individuals believe they are investing when in fact they are engaged in pure speculation.
The blurred lines between investing and speculating are being exacerbated by an increasingly crowded 24/7 financial news cycle in which talking heads opine with great conviction on near-term trends in the financial markets. Individual investors are confused and too often believe that they are missing opportunities to make money by exercising patience, taking a long-term approach and resisting the urge to actively trade.
A case in point of impatience and a near-term focus is the growing popularity of leveraged exchange-traded funds. Currently, more than $30 billion has been committed to these funds, which allow individual investors to double or even triple market or individual-sector returns. That is, they can double or triple both investment gains and losses. There are even leveraged inverse ETFs that provide the buyer the opportunity to double or triple the opposite of specific market or sector returns. So, if you believe the overall market is headed for a precipitous decline, you might buy a 3X inverse S&P 500 ETF. If the market falls by 1% on a day, your position rises by 3%. Easy money, it would seem.
The problem is that many retail investors simply don't understand the speculative nature of these funds. These funds magnify returns through the use of derivative securities -- once referred to by Warren Buffett as financial weapons of mass destruction. Just like derivatives, leveraged ETFs are dangerous in the hands of the uninitiated and are not congruent with most investors' risk tolerances. This is why we must give credit where it's due and praise the SEC for its recent move.
This article is commentary by an independent contributor. Robert R. Johnson is president and CEO of the American College of Financial Services. At the time of publication, the author held no positions in the stocks mentioned.