Are leveraged and inverse ETFs the cause of market volatility? Studies suggest they are at most a minor factor.
Wednesday's article in The Wall Street Journal stating that the SEC is making inquiries about the effect that leveraged and inverse ETFs are having on market volatility has caused a wave of paroxysm, hand waving and "I told you so!" exclamations, similar to the recent flap over high frequency trading (that's why we're down! High frequency trading!).
I have concerns about these types of ETFs as well. We need to ask a couple of questions:
1) what's the dollar value of all these leveraged and inverse ETFs? Answer: pretty small.
According to data from Morningstar, leveraged or inverse ETFs are 5 percent of the assets of all ETFs: about $44 billion of the $972 billion in total ETF assets under management.
This is small potatoes. That's a tiny part of the roughly $15 trillion in total stock market value.
What about dollar volume? Over the last 10 days, according to Morningstar, leveraged and inverse ETFs are about 13 percent of ETF dollar volume. Again, small numbers.
Laszlo Birinyi has estimated that ETFs themselves were 29 percent of total stock market volume in August. This is a substantial number, but again leveraged and inverse ETFs again appear to be a tiny part of this.
2) how much of the volume are they in the critical last half-hour of trading, given that most appear to rebalance at the close? Answer: likely not as much as you think.
There's been some very interesting work done on this by Victor Lin at Credit Suisse.
Lin examined a particularly volatile week: August 8 through 11, when the S&P 500 moved over 70 points.
According to Lin, leveraged and inverse ETFs were only five to six percent of large-cap trading in the last 30 minutes during that volatile four-day period.
Lin notes that "these values would be unlikely to cause the market to move violently."
What does he mean by that? Lin estimates that in the four days studied leveraged ETF rebalancing ranged from $1.7 billion to $2.2 billion in large caps in the last 30 minutes...is that a little, or a lot? Lin estimates it would at worst have an impact of 2.4 points in the S&P 500.
That is a very small impact. Bear in mind, on the days under study, the S&P was moving in a 50 to 70 point range — each day. A move of 2.4 points on days like that is hardly significant.
For small caps, rebalancing trading was higher: about 20 percent of total trading in the last half hour.
Mr. Lin also notes that "the rebalancing is concentrated at the end of the day and is a function of how much volatility there already was in the market (i.e., they didn't cause the market slide!)"
What about all this volume? "Trading naturally increases with volatility as portfolios are rebalanced, investment views change, risk tolerance is adjusted, and perceived opportunities arise."
Not a very exciting conclusion, but likely accurate.
These facts don't completely assuage my concerns, but they do indicate that leveraged and inverse ETFs may be less of a problem than some think.
The SEC, of course, should continue to monitor this and, in particular, make sure investors are aware of the risks of investing in them, particularly the daily rebalancing. Many brokerage firms already forbid them in retail accounts.
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