The SEC Is Rethinking Its Approach to ETFs. Here's What It Could Mean For Crypto Investors

Wall Street likes to generate fees. That's what you need to keep in mind as you examine the exchange-traded fund (ETF) sector. The early ETFs all mimicked diversified indexes, like the S&P 500 (SNPINDEX: ^GSPC). But there are only so many big indexes, so Wall Street started to get creative. The next phase of that could be the SEC allowing cryptocurrencies in ETFs. Here's what you need to know.

Too many choices, and a lot more risk

Early on, ETFs provided investors with broadly diversified portfolios. Even the ETFs that didn't track a well-known index often tracked bespoke indexes that were more focused, but still fairly diverse. Think a sector ETF like Vanguard Utilities ETF (NYSEMKT: VPU) or Vanguard Information Technology ETF (NYSEMKT: VGT). But Wall Street always goes to extremes as it seeks to generate more fees.

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Today, there are ETFs that offer returns 2x or even 3x those of an index. And they work in both a positive and negative direction, so investors can make bullish or bearish bets. There are also stock-specific ETFs, some of which provide leveraged returns, such as Direxion Daily TSLA Bull 2X ETF (NASDAQ: TSLL). That is starting to sound more like gambling than investing, but Wall Street isn't done yet.

Will cryptocurrencies be the new ETF frontier?

The SEC is seeking input from the investment community on ETFs. The general impression is that the regulator is considering opening the ETF space to more "novel" products. That could even include cryptocurrency-based ETFs. That could be a potential benefit for investors, as such products would make buying cryptocurrencies easier. And if ETFs offer diversified baskets of cryptocurrencies, they could possibly be a safer alternative to buying a single cryptocurrency.

So there are reasons to like the direction the SEC is going. However, Wall Street's push toward riskier and riskier stock-based ETFs suggests caution is in order. It seems reasonable to expect single crypto ETFs and the eventual advent of ETFs that provide double or even triple the return of a cryptocurrency. Cryptocurrencies are already risky; putting them in an ETF won't change that and could, in fact, make the problem worse.

The cryptocurrency sector could be better off

What's interesting here is that, even though crypto ETFs could be a mixed blessing for investors, they could be a huge benefit for the crypto sector. Essentially, ETFs would create a new buyer base, likely leading to more sustained demand for digital currencies. That, in turn, would support crypto prices. Still, as an investor, you have to make sure you understand what you are buying if crypto ETFs do become a thing. The risk-reward balance may end up tilted in Wall Street's favor, not yours.

Reuben Gregg Brewer has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.