Markets have been choppier lately, and once again some people think leveraged ETFs are exacerbating it. After all, even the Bank of England thinks they might be a bit dangerous.
Robin might not be blaming them, but he’s not a fan either. And he reckons the leveraged Microstrategy ETF launched last month might be the industry’s shark-jumping moment. But do leveraged ETFs really have a top-level impact on stock market volatility?
This isn’t a new freakout. Corroborating Franklin R. Edwards’ old quip that bouts of extreme market volatility tend to be blamed on “whatever new is going on at the time”, the first worries about leveraged exchange traded funds surfaced some 16 years ago, soon after they first appeared.
Very much in vogue today, the products were already so popular among professional investors by 2008 that some people apparently assumed they must have exacerbated some of the stock market volatility.
This wasn’t completely crazy thinking. Two decades earlier, portfolio insurance, or “dynamic hedging” involving then-newfangled index futures had undoubtedly “accelerated the pace” of the Black Monday crash.
But the notion that it was the daily rebalancing of leveraged ETFs rather than concerns about the longevity of capitalism itself that explained why markets post-2008 were trading a tad choppy simply didn’t hold water, argued professor William Trainor. “Trading associated with leveraged ETFs does not appear to have any substantial effect” on an index as big as the S&P 500, he concluded in a 2010 paper.
Others disagreed, including Wall Street veteran Douglas Kass: leveraged ETFs are “new weapons of mass destruction,” he said at the time, and had “turned the market into a casino on steroids”.
The leveraged and inverse equity ETF industry has grown rapidly since then, though it hasn’t necessarily matured.
Assets under management swelled from $30bn to $140bn over the past 14 years (about four-fifths of leveraged ETFs have long equity exposure; the rest are inverse, or short) alongside the emergence of products like Defiance ETFs’ long leveraged ETF for MicroStrategy, the 2x Super Micro Computer ETP and Leverage Shares’ 3x ARK Innovation Long.
Buy-and-hold products these most certainly are not: the nature of the beast means that over weeks and months the performance of leveraged and inverse ETFs often differs significantly from the products they track, particularly in more volatile markets.
So it makes sense then that following early-August’s “vol shock” analysts are again wondering whether the daily rebalancing trades of these high-risk, high-fee investment vehicles might be stoking broader stock market turbulence.
JPMorgan waded into the debate this week, opening with some first principles:
The vast majority of leveraged/inverse ETFs . . . need to reset or rebalance their exposure on a daily basis in order to drive their leverage back to target levels. They typically place orders near the end of each trading session. This daily resetting, which involves leveraged ETF mechanically buying more of their underlying equity index or stock exposure in up days or selling in down days, in principle amplifies equity market moves towards the end of each trading day.
So how big are these rebalancing flows today, and what impact are they having on wider price swings?
Well, JPMorgan analysts Nikolaos Panigirtzoglou, Mika Inkinen, Mayur Yeole and Krutik P Mehta estimate that each percentage point change in equity indices generates around $6bn of rebalancing flow by leveraged ETFs globally.
In other words, pretty insignificant in the grand scheme of things, but JPMorgan’s analysts say the impact could be greater when markets are choppier.
This $6bn rebalancing flow corresponds to one percentage point change in underlying equity indices and its amplification impact would be much bigger in days when equity market changes are more violent and liquidity conditions are typically impaired.
On the other hand, they concede (citing a 2014 Federal Reserve paper titled Are Concerns About Leveraged ETFs Overblown?) that “contrarian” capital flows mean the size of the moves associated with leveraged ETF rebalancing are “not always as big as implied” by their own calculations.
The Fed paper notes that capital flows can either increase or decrease ETF rebalancing demand “because flows alter the size of an ETF, which in turn affects the amount of additional leverage the ETF requires to maintain its target leverage ratio”.
Imagine for a second you bought an Alphaville 5x BryceCorp ETF . . .
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On Monday, the price of underlying BryceCorp stock (generously priced at $100) rises 2 per cent, so the ETF rises 10 per cent.
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BryceCorp ends the session at $102 and the ETF ends the day at $110 (with exposure of $510)
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If the fund manager didn’t rebalance at the end of the day, the ETF’s leverage factor would fall to about 4.6x (510/110). So it buys another $40 of exposure to meet its 5x mandate
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But if investors take part profit by pulling money out of the ETF on the same day (eg a negative capital flow of -$5), this reduces the total amount of buying the ETF provider needs to do, too, ie $40 — $5 = $35 of rebalancing
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Thus a (typically) contrarian capital flow in leveraged ETFs — which are more used as a short-term trading tool — would somewhat reduce the amplification effect from the end-of-day buying (or selling)
Under a mean-reversion trading strategy, for example, “investors would increase (decrease) their exposure to leveraged ETFs following negative (positive) index returns”, according to the Fed paper. Momentum traders would behave in the opposite fashion. In other words, some of the ETF-induced moves at the end of each day should (theoretically) be arbitraged away.
The authors thus concluded that capital flows “considerably reduce ETF rebalancing demand and, therefore, mitigate the potential for ETFs to amplify volatility”.
JPMorgan only partially agrees (emphasis our own):
Such contrarian flows occurred in the most recent equity market correction, as shown in Figure 18. For example on September 3rd during an intense equity correction, we estimate that leveraged and inverse ETFs had to sell $14.5bn of underlying equity exposures, but investors injected $1.5bn during that day, thus offsetting some of the rebalancing flow.
However, during days when the equity market rebounded sharply i.e. July 22nd, capital flows acted as an amplifier rather than a dampener, ie capital inflows meant that during that day leveraged ETFs had to buy $3.4bn more than the rebalancing flows of $8.5bn.
In general , during days when equities are significantly lower, capital inflows tend to mitigate the rebalancing-related equity selling of leveraged ETFs, while during days when equities are significantly higher, capital inflows tend to amplify the rebalancing-related equity buying of leveraged ETFs.
Asym 500’s Rocky Fishman has “some concerns” with JPMorgan’s logic, however. He points out that capital flows happen throughout the day, rather than just around the market close.
As a result, they’re not going to have the same point-in-time amplification effect as rebalancing flows. I believe that for certain products the capital flows might only be allowed at the close, but in that case an order that results in a create/redeem will be hedged early in the day so economically it’s early in the day regardless.
Capital flows in/out of leveraged ETFs are only one type of offset against the rebalancing flows; in reality all ETF and mutual fund flows should be offsetting the rebalancing flows.
Fishman also points out that blaming end-of-day rebalancing for early-August’s volatility neglects the fact that most of the action a month ago “happened outside US trading hours”:
“On a day-to-day basis, [the impact from leveraged ETFs] isn’t that noticeable,” he adds. “But they could become a factor if there’s a sharp end of day move in an illiquid market. If some event happens at 3.58pm on a trading day, say, these products could have an impact”.
In sum, then, it seems like leveraged ETFs contribute to S&P 500 volatility at the margin, with smaller indices more vulnerable to their end-of-day flows and macro factors like rates, CPI, employment figures etc probably deserving of the bulk of the blame. Just like in 2008.
https://www.ft.com/content/0a9f9590-9135-4d70-af0e-add3ee4812fe
