SmartStops comment: Interesting to see that the SEC is now investigating whether leveraged ETFs are a cause of increased market volatility. When will the public realize that the basic underlying structures fueling our stock markets around the world have changed in our 21st century. There are so many more instruments and derivatives that create the need for a more dynamic intelligent risk management approach. Asset allocation and diversification, the tenets of modern portfolio theory are not enough in this day and age. This is exactly why the SmartStops service was created.
originally published at ETF Trends.
Leveraged exchange traded funds are being blamed for the wild volatility in stocks last month, but data and empirical evidence show the concerns are way overblown.
“With equity volatility doubling recently, some of the same topics that came up two years ago during the credit crisis have resurfaced as people look for possible culprits,” Credit Suisse said in a recent report. “ETFs have received some blame for the increasing volatility, although we believe it’s a case of confusing correlation with causation.”
The Wall Street Journal reports the Securities and Exchange Commission is looking into whether leveraged ETFs magnified the market’s wide swings in August. [SEC Reportedly Probing Whether ETFs Added to Market Volatility]
Many leveraged ETFs are geared to provide 200% or 300% of the daily moves in stocks. “Inverse” leveraged ETFs rise when stocks fall. These high-octane funds need to rebalance every day to provide the desired performance.
“Our findings show that the leveraged ETF rebalancing trades are unlikely to be the most influential factor in driving intraday swings into the close,” Credit Suisse said in its report. “Less liquid spaces like small caps and specific sectors may be more likely to be affected on rare days with extreme moves, but liquidity needs are often quickly met in the same way as for typical index rebalances that occur throughout the year.”
Morningstar ETF researcher Scott Burns told the WSJ that although leveraged ETF trading jumped along with market volatility in August, they likely didn’t play a major role in the swings because not enough cash is invested in the funds.
Leveraged exchange traded products hold assets of $35 billion, with short and ultra-short products accounting for about $22 billion of the total, according to a recent report from Barclays Capital. There is about $1 trillion invested in all ETFs. [Understanding the Basics of Leveraged ETFs]
According to Morningstar, leveraged and inverse ETFs represent just 5% of total assets held in ETFs, MarketWatch reported.
Josh Lukeman, head of ETF and index swap trading at Credit Suisse in the Americas, in a recent New York Times report discounted the theory that leveraged ETFs are boosting market volatility. Lukeman noted that the leveraged funds did not trade enough to have any outsize impact, according to the paper.
“He did note that short-term traders would often buy or sell indexes around 3 p.m., hoping to get in front of the trades that leveraged ETF’s have to make before the close of trading that day,” the NYT reported. “But he said he doubted that that alone could explain the increased volatility in recent weeks.”
Although total ETF trading volume has risen dramatically in recent years, much of the action is concentrated in the largest funds such as SPDR S&P 500 (NYSEArca: SPY). For example, trading the ETF accounted for more than a third of all volume last month, according to a report. [ETF Trading Volume Rises]
ETFs have faced more scrutiny as assets and trading volume in the financial products have ramped higher in recent years. They experienced “busted” or cancelled trades during the flash crash in 2010, but regulators found no evidence they contributed to the event.
The SEC has been examining derivatives for years, and although regulators continue to look at inverse and leveraged ETFs, there are no signs of any sweeping changes forthcoming.
“It’s understandable for the investment community to look for possible explanations in periods of extreme volatility,” Credit Suisse said.