October 11, 2011
Is The Levered ETF Tail Wagging The Market Dog?
Douglas Kass of Seabreeze Partners tells Andrew Ross Sorkin that levered ETFs "have turned the market into a casino on steroids. They accentuate the moves in every direction — the upside and the downside.”
Sorkin thinks that levered ETFs were the source of Monday's stock market surge 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," he writes.
Levered ETFs are a relatively recent innovation and a fast-growing business. Equity ETFs hold more than $15 billion in assets, according to ETFdb.com. The largest is ProShares UltraShort S&P 500 (SDS), with $2.7 billion in assets and average daily trading volume in excess of 50 million shares. Not too shabby for a five-year-old fund. There are also levered ETFs for other asset classes, including bonds, REITs, commodities and currencies. You can also find open-end mutual funds in the levered space. Overall, Sorkin estimates the total levered fund category at $1 trillion.
The key issue is the daily rebalancing aspect of these products. Sorkin explains via Kass:
At the end of every day, leveraged E.T.F.’s have to rebalance themselves by buying and selling millions of shares within minutes to remain properly weighted. If the E.T.F. made money that day, to remain balanced it has to reinvest the proceeds and leverage them again. In many cases, leveraged E.T.F.’s use options, swaps and index futures to keep themselves in balance.
But it's also true that levered funds in the aggregate make bullish and bearish bets. Over time, and perhaps at the end of each day, the net effect is a wash. Or is it? Unclear. Sounds like a topic for deeper analysis.
Meantime, what is clear is that worrying about levered ETFs is old hat. In 2009, for instance, Jason Zweig advised that "new research suggests that on days when the indexes make big moves, leveraged exchange-traded funds could trigger a trading cascade, turning the market close into a buying or selling frenzy."
As the levered ETF industry grows—Sorkin says it's "perhaps the hottest rage in investing"—the risk of this tail wagging the dog rises. True, levered ETFs can be productive tools, assuming they're used intelligently by sophisticated investors and money managers. But it's easy to abuse these potent portfolios. That's the nature of leverage: it exacerbates market moves, and investor behavior—good and bad.
Perhaps Todd Shriber sums it best by reminding that "leveraged and inverse ETFs are not investments. They are trades."
Posted by jp at October 11, 2011 5:23 AM
In a way, the ETFs are a bit like the old bucket shops, as it's not actually clear if they do fully hedge themselves - there is such divergence from the underlying index over time.
So essentially opening an ETF position is the ETF issuer taking a position against the ETF owner, which they may or may not hedge, exactly like the tickets written in the old bucket shops. And the massive losses by the UBS delta one trader suggest that prop desks are at it too.
I would love there to be a proper investigation and regulation of the ETF sector - too often the short funds go down, even if the underlying has gone down as well, and they should be punished for their tracking error. I'm surprised that no one has sued them yet.
Posted by: tgma at October 11, 2011 6:33 AM