Leveraged ETFs dodge blame for volatility

The US Federal Reserve has warned that leveraged exchange-traded funds could pose a systemic risk through their rebalancing activities, but many exchange-traded fund providers think these claims are overblown

When the US Federal Reserve speaks, people tend to sit up and take notice. So when the central bank published a report warning about the systemic risks posed by leveraged and inverse exchange-traded funds (LETFs) earlier this year, it attracted plenty of attention in the media and among investors.

It is not the first time regulators have expressed concern about the possible systemic impact of the exchange-traded fund (ETF) sector – separate reports from the Bank for International Settlements, Financial Stability Board and International Monetary Fund were published almost simultaneously in April 2011. But, while the ETF industry accepted elements of the criticisms directed at them then, some are adamant the concerns expressed in the current report are overplayed and express doubt that a relatively small sub-sector of the ETF industry could create a broad, system-wide disaster.

Some investors use LETFs to hedge their portfolios against upward or downward movements in the market, or to seek exposure to a specific index or currency, because they feel that index or commodity will either do well or poorly in the short term.

Many LETFs have to rebalance portfolios daily, and anecdotal evidence suggests they typically do so an hour before the closing bell. In practice, LETFs do not need to directly trade in the stock market to rebalance their portfolios, instead employing derivatives for this purpose.

If LETF rebalancing exerts significant price pressure, this could amplify market movements and the paper from the US Federal Reserve asserts it is plausible that, during periods of high volatility, their impact in response to a large market move could reach a tipping point for a “cascade” reaction.

However, Townsend Lansing, head of short and leveraged platforms at ETF Securities in the UK, is one who thinks the Fed’s fears are overplayed. He says how ETF Securities’ short and leveraged products rebalance is “not necessarily programmatically required” and is based on a derivatives contract with a counterparty. He believes that guaranteed rebalancing on a leveraged basis means, in theory, that LETFs might have an effect, but the volumes involved are “a drop in the bucket in terms of the trading done in equities. It’s no different to a hedge counterparty with derivatives exposure that has to hedge themselves against market movement. There’s nothing in the products that makes them inherently unstable for market activity.”

The paper, published in August, nevertheless asserts that the implied price impact of LETF rebalancing on financial markets was notable – especially during the 2008–2009 financial crisis and in the second half of 2011, during the height of the European sovereign debt crisis. In fact, the frequency of a large price move in the last hour of trading was zero until 2007, when the first financial LETF was launched. A 1% increase in broad stock market indexes induces LETFs to originate rebalancing flows equivalent to $1.04 billion worth of stock, the paper found. If the S&P 500 index goes up 1%, LETF rebalancing demand results in a 6.9 basis-point (bp) increase in price and a 22.7bp increase in daily volatility in an average large cap stock.

The paper draws comparisons between LETFs and portfolio insurance strategies that contributed to the stock market crash of October 19, 1987. In addition, the ‘Flash Crash’ of May 6, 2010 was triggered by a $4.1 billion (75,000 contracts of E-Mini S&P 500 Futures) sell order, equivalent to only 3% of the E-Mini S&P 500 Futures daily volume. With a large market move, for example 4%, the total rebalancing flows of LETFs would be equivalent to this Flash Crash order, concludes the paper.

One US head of equity structured products believes “there is some accuracy in the report”. He says: “It’s similar to portfolio insurance in the 1980s. In rising markets, the daily resetting mechanism of these products requires the hedgers to go in and buy more or sell in falling markets and this always happens around the close. For sure, I think these daily resetting products will contribute to market volatility.”

The question is how much, and the impact is found to be greater in smaller cap stocks, such as those in the Russell 2000 Index. The paper says hypothetical rebalancing flows are considerable for an average stock in financial and small stock categories, being up to 8% and 18% of volume in the last hour of trading, respectively.

A study conducted by Dave Nadig, president, ETF analytics at IndexUniverse, and SM Borup tallies with this aspect of the Federal Reserve paper. The study, focused on a six-month period at the start of this year, found inconclusive evidence of ramping activity in the last hour before close in broad large- and mid-cap indexes. But, two-thirds of the time, the Russell 2000 ramps to the close throughout the last hour of trading, either up or down. The study confirmed financial stocks are more inclined to ramp into the close than any other corner of the large-cap market, as is the tech sector.

Howard Tai, a senior analyst with consultant Aite Group, also suspects LETF rebalancing will have a disproportionate effect on sector funds. He says of the Federal Reserve paper: “The author is probably onto something in that there will be smaller cap financials and technology companies that tend to be less capitalised. When you compare the assets under management (AUM) of the LETFs relative to the market cap of the stocks that comprise them, the rebalancing at the end of the day could have a knock-on effect and push them more than it actually should.”

The predictability of mechanical rebalancing also raises the likelihood that aggressive-oriented institutions are front-running LETFs, although there is clearly no certainty that the market will move in a particular direction.

The US head of equity structured products says: “You can’t just say, ‘if the market’s down at 3:30pm, I’m going to sell’. I’ve looked at it personally and maybe only 50% of the time that trade works, which is effectively meaningless – there is no information. But if you impose constraints – if you say, ‘if the market’s down more than 50bp by 3:30pm, I’m going to short’ – then the results are different. You will find that there is some information in that.”

He adds, however, that the higher the movement hurdle set before a trade is triggered obviously reduces the frequency of those instances occurring. “If the trigger is a 1% movement, you might have a situation over the past five years where two out of every three trades went in your favour. But, if the trigger only happens 17 times in those five years, that’s not a sound basis for a trading strategy.”

The paper asserts that LETFs and anticipatory traders in the same direction are stronger than the traders on the opposite side. Without the traders taking the other side of the LETF rebalancing activity, the end-of-day effect of the LETF rebalancing could be destabilising.

Market response to positive LETF flows was also found to be slightly stronger. One explanation for this could be that market participants that trade in anticipation of LETF flows could be constrained by short-selling and cannot implement their strategy in market downs as well as in market ups.

Aite Group’s Tai agrees that other players in the market might have an inkling which way the market is heading and could jump in before rebalancing flows, amplifying their movement. But he thinks this is no different than market participants knowing what dealers’ options books may look like. “If the markets are going strong towards the end of the day and the dealers’ options books are short gamma [a measure of the convexity of a derivative’s value, in relation to the underlying] they have to buy stocks as the market goes into close, or vice versa, in order to hedge themselves. The anticipatory trades could be a combination of market participants knowing that dealers are short gamma in these sectors. It’s not just LETFs rebalancing that’s causing the extent of the movements on particularly volatile directional days.”

Empire strikes back
Others are also less than convinced by the findings of the Federal Reserve paper. A source close to the Securities and Exchange Commission (SEC) tells ETF Risk that it is important to note that rebalancing at the end of the day for a leveraged fund is always in the direction of the market. Yet, in August 2011, at the height of the debt crisis, “a lot of the moves that caught the attention of people when the market was gyrating wildly in the last 20 minutes had a huge reversal. They could not be blamed on the rebalancing of LETFs because they were in the wrong direction.”

The source close to the SEC adds: “That’s not to say rebalancing can’t have an effect and that is a valid question. It might be a tempest in a teapot, but we wouldn’t want to discount that LETFs might have an effect. Crucially, the paper says LETFs ‘could’ have an effect. The paper falls short of saying LETFs definitely do have a negative impact. The potential for that impact is certainly there, given LETFs continue to grow, but I would like to see more empirical research into the subject.”

Globally, according to consultancy ETFGI, as of the end of September 2013, there were 263 leveraged ETFs/exchange traded products (ETPs) with $23.2 billion in assets, 223 inverse ETFs/ETPs with $9.7 billion in assets, and 177 leveraged inverse ETFs/ETPs with $17.1 billion in assets. These products accounted for 1.0%, 0.4% and 0.8% of global ETF/ETP assets, respectively. In total, that is 663 ETFs/ETPs with $50.1 billion in assets, accounting for 2.2% of global ETF/ETP assets. This should be taken in further context: global AUM in mutual funds are around ten times that of all ETFs.

A second source close to the SEC says because LETFs represent such a tiny part of overall assets, they could only be a problem if their market share increased. The source says: “It is definitely something we consider impacts on our market, but they’re too small a piece of the pie. We are looking into it, however, and trying to determine, if they became a much larger slice of the pie, whether the theory would hold that they can have a destabilising effect.

“LETFs are but one type of pooled vehicle that accomplishes a similar strategy. There are also leveraged and inverse mutual funds in the US, exchange-traded notes as well as private funds that pursue leveraged and inverse strategies. There are a lot of players doing that and it’s hard to detect whether an impact is being felt from ’40 Act-registered ETFs.” The 1940 Act regulates funds in the US.

It cannot be denied that many other factors also play a role in driving stock prices at the end of the trading day. Day traders, for instance, are typically long investors and close out positions before the final bell, resulting in buying pressure at the opening of each session and selling pressure at the close.

LETF issuers themselves are at pains to deny their products can have an impact on market volatility. In a blog, UK-based LETF player Boost ETP moved quickly to play down the significance of the Federal Reserve research, calling the paper “simplistic in approach” and “a headline-grabber [that] doesn’t stand up to real-world scrutiny.”

Boost points out that LETFs typically employ leverage factors of two or three times the return of the index, while other types of leveraged trading vehicles – including prime brokerage accounts, futures, options and covered warrants – can create leverage of up to 20 times.

At US provider Direxion, meanwhile, which has 49 LETFs, Andy O’Rourke, managing director and chief marketing officer, says: “The paper is a non-event with no new information. There is no evidence to suggest there is an impact on volatility. These products lack the magnitude to have an impact.” He says the SEC conducted an analysis into how Direxion funds operate, the timing they employ and how the firm trades to achieve its daily investment objectives, and finished by determining that no further action was needed.

Rourke says Direxion’s products rebalance daily, typically in the last hour of trading. But, occasionally, when markets are particularly volatile, it may move assets earlier. Direxion uses total return swaps to rebalance the majority of its funds, while its swap counterparties hedge using baskets of equities, non-leveraged ETFs, futures or other derivatives.

A source close to the SEC concurs that, in most cases, funds do not go out and buy stocks at the end of the day and rebalancing by LETFs almost exclusively occurs through derivatives, bought through large dealers, in whose interest it is to make the smallest possible market impact. He adds: “We spent some time looking at it and, as soon as you start to pull on it, it looks a lot more complicated than saying ‘this is affecting 8% of the following stock’, because it’s not necessarily the case anyone is buying that low liquidity stock. It’s often that the derivatives are based just on the indexes and you will have large firms hedging that appropriately.”

However, the author of the Federal Reserve paper, Tugkan Tuzun, maintains: “If they trade futures contracts, index arbitrageurs will transfer this effect from the futures market to the stock market. If they enter into a spot agreement, their counterparty is likely to hedge its exposure and trade in either the futures or the spot market. As a result, regardless of the contracts LETFs trade, their portfolio rebalancing should leave an imprint on the stock indexes they target.”