## Tuesday, November 1, 2011

### Can Leveraged ETFs Cause Market Instability?

Canadian Couch Potato took a detailed look at whether leveraged ETFs can cause market instability including links to other opinions on the subject. Missing in the various articles I read was a clear and simple explanation of the forces that can cause leveraged ETFs to add to market volatility.

2X Bull ETF

Consider first an ETF that seeks to give double the daily return of a given stock index. Suppose that investors have invested a total of \$100 million. There are many ways for an ETF to gain double exposure, but we'll look at a simple method: the ETF borrows another \$100 million and buys \$200 million worth of index stocks.

At the start of the day the ETF holdings are

Stock: \$200M
Cash: -\$100M

The ETF's goal is to maintain a 2:1 ratio between stocks and borrowed cash. Let's now look at what happens on a volatile day. If stocks go up 5%, the holdings are now

Stock: \$210M
Cash: -\$100M

At the end of the day, the ETF has to borrow another \$10 million to buy stock to get back to a 2:1 ratio:

Stock: \$220M
Cash: -\$110M

Suppose that instead of going up 5%, the market had dropped 5%. Then the ETF holdings are

Stock: \$190M
Cash: -\$100M

At the end of the day, the ETF has to sell \$10 million worth of stock to get back to a 2:1 ratio:

Stock: \$180M
Cash: -\$90M

Note that no matter which way the market moves, the ETF trading pushes the market further in the same direction. If the market goes up, the ETF starts buying stocks to drive it higher. If the market goes down, the ETF sells stocks to drive it lower.

2X Bear ETF

We might hope that an inverse ETF would have the opposite effect, but this isn't the case. Suppose that investors have invested a total of \$100 million in a double inverse ETF. Again, there are many ways to gain double inverse exposure, but we'll look at the direct method: the ETF borrows \$200 million worth of stock and sells it.

At the start of the day the ETF holdings are

Stock: -\$200M
Cash: \$300M

The ETF's goal is to maintain a 2:3 ratio between stock debt and cash. If stocks go up 5%, the holdings are now

Stock: -\$210M
Cash: \$300M

At the end of the day, the ETF has to buy \$30 million worth of stock to get back to a 2:3 ratio:

Stock: -\$180M
Cash: \$270M

Suppose that instead of going up 5%, the market had dropped 5%. Then the ETF holdings are

Stock: -\$190M
Cash: \$300M

At the end of the day, the ETF has to borrow and sell \$30 million worth of stock to get back to a 2:3 ratio:

Stocks: -\$220M
Cash: \$330M

Once again no matter which way the market moves, the ETF trading pushes the market further in the same direction.

Conclusion

So, leveraged ETFs do add to market instability, but an important question is how much? If the bulk of investor money were in leveraged ETFs then the added volatility would be a problem. But, as Canadian Couch Potato pointed out, leveraged ETFs are just a small part of the market. Another good point he makes is that regular ETFs that include no leverage, swaps, or derivatives do not add to market instability.

1. Thanks for the mention, and for these examples. One issue I did not discuss is that most leveraged and inverse ETFs primarily get their exposure through derivatives, so they are not necessarily trading any stocks directly. The hedge fund manager who said that these ETFs "have to rebalance themselves by buying and selling millions of shares within minutes" was not accurate in most cases.

2. @Dan: It's true that the exposure is often done with derivatives. However, some fraction of derivative trading drives trades in the underlying asset. So even in cases where exposure is achieved with derivatives, there is some added pressure toward greater swings in the underlying. That said, I doubt that the effect is very great.

3. Whether they trade derivatives or stock, leveraged ETFs do move stocks at the close of trading.

But more importantly, these products are not understood by the individual investor (who fails to read the fine print). These are for day trading ONLY and not for longer-term investing.

In my opinion, these products are poison and serve no useful purpose. It it really that difficult or expensive for the customer to trade twice as many shares of the single, regular, unleveraged ETF?

4. Leveraged ETFs are a strange thing since they reset every day. Just as this prevents them from truly matching the market performance over a longer period like 3-12 months, I doubt they have the full market impact we would expect.

Real leverage does of course. If someone borrows money 3 to 1 (or 30 to 1 if they're an investment bank) to bet on a decline in the market for a year they should have a bigger impact than someone using a leveraged ETF.

5. @Mark: It's good to see that an option guy confirms my contention that derivative trading moves the underlying stocks. I agree with your point that typical investors do not understand how the daily reset affects long-term returns in leveraged ETFs.

@Value Indexer: My guess is that market impact is largely driven by the amount of money invested in leveraged ETFs, which is not very high right now.

6. All this frenetic rebalancing is poison to investment returns as a previous post of yours illustrated. How often does a plain-vanilla ETF rebalance, only when the underlying index components change? If so, it seems these plain ETFs are much more efficient at minimizing costs.

7. @Gene: I agree. Simple ETFs that own a broad index are for investors. Leveraged ETFs are for traders who (hallucinate?) that they can see short-term future market direction.

8. Wow, this is extraordinarily counterintuitive. Thanks for pointing it out.

9. @Patrick: For me the counterintuitive part was that both the bull and bear ETFs drove instability in the same way.

10. @Michael: yes, exactly. I'm still trying to reconcile that with my intuition that the bear fund should be the opposite of the bull fund...