Leveraged exchange-traded fund (ETFs) that seek to provide a multiple return, usually 2x or 3x, of the underlying benchmark have come under fire as naysayers falsely accuse the recent bout of market volatility on this investment vehicle.
Some of the products are inverse bearish products that move in the opposite direction of the market they track. During volatile markets, like now, investors may capitalize on the quick market movements, especially through leverage strategies that would provide a multiple of the normal returns.
ETFs that provide a leveraged strategy rebalance on a regular basis to achieve their intended leveraged targets. Most leveraged ETFs adhere to a daily reset, and as a result of the daily rebalancing, the multi-day return will not perfectly reflect a 2x or 3x performance of the underlying index. Additionally, the daily-reset ETFs may underperform during highly volatile situations and outperform during low volatility.
Additionally, some leveraged products may provide leveraged returns over a multiple-day period. These ETFs attempt to reflect the stated leverage at trade multiplied by the total return of the underlying benchmark-so, a fund might reflect 2x or 3x performance of an underlying benchmark over a multi-day period. For instance, some leveraged ETFs will rebalance holdings on a monthly basis. However, this type of leveraged fund will stop trading and will be recalled at the ending net asset value if the NAV dips below a predefined point.
Most of the recent hubbub over leveraged ETFs was put into focus after the Wall Street Journal reported that the Securities and Exchange Commission was looking into whether leveraged ETFs magnified the volatile swings the stock market experienced last month. However, the SEC has been placing a greater scrutiny over the industry for some time now, and this is not really anything new. Market analysts have argued that investors should not confuse the correlation between high volatility and interest in leveraged ETFs with causation.
Industry observers have noted that while leveraged ETF trades have jumped along with market volatility in August, the funds themselves did not play a large role in the swings since they are only a small segment of the overall ETF industry. Overall trading in ETFs jumped over 100% in August, but the total trading volume of ETFs only accounted for around a fifth of overall ETF shares traded for the month.
According to Morningstar research, leveraged and inverse ETFs amount to 5% of total assets held in ETFs. There is a little over $1 trillion invested in all ETFs, whereas leveraged exchange-traded products hold around $40 billion and around half that amount is in inverse funds.
Furthermore, it should be noted that since inverse equities-based and leveraged equities-based ETFs hold a similar amount of assets, any movements in one subset would be offset by the other, making the impact on the markets quite minimal. Consequently, the net effect of all trading in these funds may be reduced to a couple of million dollars, which is drastically miniscule compared to the trillions floating around the equities market.
Opponents of leveraged ETFs have also been quick to point out that leveraged funds have been traded heavily during the end of a trading day as people would try to capitalize on the daily rebalancing mechanism. However, research from Credit Suisse reveals that the elevated trades in leveraged ETFs have followed the general trading trends at the end of the day, and they have actually provided additional liquidity for trades. The last hour in U.S. stock trading for the year has not been any more volatile than the rest of the day.
ProShares is the largest provider of leveraged ETFs. They offer leveraged funds that cover most of the largest asset classes, sectors and sub-sectors.