Leveraged ETFs ratchet up market volatility

Published October 12, 2011


ETFs, which allow investors to bet on a certain basket of stocks, commodities or an index, are perhaps the hottest item now in investing with some US$1t invested


(NEW YORK) Did you watch the markets on Monday? In the last 18 minutes of trading, the Standard & Poor's 500- stock index jumped more than 10 points with no news to account for the rally. If you were left scratching your head, you were not alone.


Ouch: Almost every day there is a story in the papers trying to explain the stock market's wild swings and often they are inconclusive as everything from Europe's banking problems to new fears of recessions are raised
Almost every day there is a story in the newspaper trying to explain the stock market's wild swings, or 'volatility' and often they are inconclusive as everything from Europe's banking problems to new fears of recessions are raised. Through the summer and into autumn, I too have been pondering the gyrations in trading, especially the late-day sell-offs and rallies that seem to always be timed perfectly to coincide with the closing bell. Rarely do the rallies or sell-offs, which invariably start after 3pm, justify three- and four-percentage point moves.

The swings have a deleterious effect on the markets because they undermine confidence and investors start sitting on the sidelines. And then I started talking with investors like Douglas A Kass, a long-time Wall Street denizen who is the founder and president of Seabreeze Partners Management. He says he knows the culprit for the late day market swings: leveraged exchange traded funds or ETFs.

These funds, which allow investors to bet on a certain basket of stocks, commodities or an index, are perhaps the hottest rage in investing with some US$1 trillion invested. ETFs are particularly attractive to some investors because you can bet long or short - and you can leverage your bet. And you can hop in and out within the trading day to lock in gains, just as with stocks.

If you bet US$100 that the ProShares Ultra S&P 500 would rise by one per cent on a given day, and it did so, say by 3pm, you could settle the bet and receive double the return - in this case 2 per cent (excluding fees). Of course, if the market goes in the opposite direction, you could lose 2 per cent. There are also what are called 'inverse' leveraged ETFs that go up when the basket of goods goes down, and vice versa.

To Mr Kass, these ETFs are the 'new weapons of mass destruction'. (His description is an homage to Warren Buffett's famous line that derivatives are 'weapons of mass destruction.') 'They've turned the market into a casino on steroids,' Mr Kass said. 'They accentuate the moves in every direction - the upside and the downside.'

Mr Kass, who has written about this topic for The Street.com may be right: At the end of every day, leveraged ETFs have to rebalance themselves by buying and selling millions of shares within minutes to remain properly weighted. If the ETF made money that day, to remain balanced it has to reinvest the proceeds and leverage them again. In many cases, leveraged ETFs use options, swaps, and index futures to keep itself in balance.

Consider the ETF the new derivative. 'It is these derivatives and not the phenomenon known as high-frequency trading (HFT) - commonly critiqued as contributing to the 'flash crash' of May 6, 2010 - that pose serious threats to market stability in the future,' Harold Bradley and Robert E Litan of the Kauffman Foundation wrote in a controversial paper last year.

'The SEC, the Fed, and other members of the new Financial Stability Oversight Council, other policymakers, investors, and the media should pay far more attention to the proliferation of ETFs and derivatives of ETFs.' Mr Bradley and Mr Litan contend that it is the 'rebalancing risk' of ETFs that makes them particularly dangerous.

In 2009, Barclays Global's research department studied the growing leveraged ETF market - before the flash crash - and concluded that the funds created systemic risk because they 'amplify the market impact of all flows, irrespective of source'. That's not to suggest that the view that leveraged ETFs are responsible for the market's volatility has not gone unchallenged.

William J Trainor Jr, a professor at East Tennessee State University, conducted an extensive study of market volatility at the beginning and the end of the market day and concluded that ETF rebalancing had nothing to do with it. 'Intra-daily volatility in time periods not associated with rebalancing saw the same spikes in volatility as the last 30 minutes did,' he said in his report. Mr Kass, who has been trading since the 1970s, scoffs at this notion.

'Ask any hedge fund manager what their gut says,' he protested. I took an informal poll of a half dozen brand- name fund managers and virtually all of them agreed with Mr Kass. Exacerbating the problem, some of them said, was the high-frequency traders, which themselves trade ETFs, which some suggested may be magnifying the problem even more.

'We know ETFs are the dominant factor in the marketplace,' Mr Kass said with certainty. 'In the '70s and '80s it was the mutual funds, in early 2000s it was the hedge funds. Now it's the algorithms running the ETFs.' - NYT