The U.S. Securities and Exchange Commission (SEC) is cracking down on exchange-traded funds (ETFs) that employ aggressive leverage strategies, signaling a potential shift in the regulatory landscape for these high-risk investment products. On Tuesday, the SEC issued a series of warning letters to prominent ETF providers, including Direxion, ProShares, and Tidal, effectively halting the introduction of new leveraged ETFs that seek to amplify daily returns by two or three times.

The letters, nine in total and nearly identical, convey the SEC's concerns that the risk exposures of these funds may exceed the limits the agency permits relative to their assets. The SEC has directed the fund managers to either revise their investment strategies to address these concerns or formally withdraw their applications.

The core issue lies in the degree of leverage these ETFs employ, with the SEC expressing unease about funds seeking to provide more than 200% (2x) leveraged exposure to underlying indices or securities. The agency's move marks a notable departure from its recent permissive stance on fund approvals, which has seen the greenlighting of various crypto-linked ETFs, private-asset vehicles, and increasingly complex trading strategies.

These leveraged ETFs have gained popularity among investors seeking to magnify potential profits, utilizing options to amplify returns. Trading volumes in these products have surged since the pandemic, as traders seek an edge in fast-moving markets, with assets climbing to $162 billion. However, the SEC is concerned that these funds, which combine high leverage with daily trading resets and exposure to volatile assets like single-name stocks and digital tokens, may be measuring risk against benchmarks that don't accurately reflect the true volatility they amplify.

The SEC's Division of Investment Management unusually and quickly posted the warning letters, suggesting the regulator wants to rapidly communicate its concerns.

The warning letters also spotlight the SEC's apprehension regarding ETFs with exposure to single-name stocks and cryptocurrencies. These funds, often employing leveraged or inverse strategies, amplify the price movements of the underlying individual stocks or digital assets, potentially leading to greater volatility and risk for investors.

According to Strategas ETF strategist Todd Sohn, ETF issuers were attempting to push beyond the established 2x leverage limit, seeking to exploit certain definitions to circumvent regulatory constraints. Some of the ETFs in question even aimed for 5x leveraged exposure to volatile stocks like Tesla and Nvidia, as well as digital assets like Bitcoin and Ethereum.

These leveraged ETFs have faced criticism due to their complexity and the potential risks they pose, especially to less experienced investors. The SEC's recent actions suggest a renewed focus on investor protection and a more cautious approach to approving novel and complex ETF products.