Leveraged exchange-traded funds came under fire recently when some investors blamed the recent bout of market volatility on these vehicles. The Wall Street Journal reported that the SEC was looking into whether leveraged ETFs had magnified the volatile swings in the stock market in August.
These funds offer a multiple return, usually doubling or tripling an underlying benchmark's normal return. There are also inverse bear products that move in the opposite direction of the markets they track. During volatile markets like the recent one, investors can capitalize on quick movements using these multiple strategies.
Controversy
There was a lot of hubbub surrounding the Journal's article, but the SEC has been eyeing this industry for some time now, and it's not really anything new. Furthermore, there is plenty of evidence that the claims made against these vehicles are false. Credit Suisse analysts have argued that even if there's some correlation, leveraged ETF activity is not a direct cause of market swings.
In fact, industry observers note that while leveraged ETF trades jumped along with market volatility in August, the funds themselves did not play a large role since they are only a small segment of the ETF industry.
According to Morningstar research, leveraged and inverse ETFs amount to only 5% of total assets held in ETFs. There is a little over $1 trillion invested in all ETFs, whereas leveraged ETF products hold around $40 billion. About 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 miniscule compared with the trillions floating around the equities market.
The impact of leveraged ETFs on the market is "marginal at best," Credit Suisse analysts wrote in a recent report, adding that leveraged ETFs were "most likely not to blame for the recent market swings."
Opponents of leveraged ETFs also point out that leveraged funds are traded heavily during the end of the day because people are trying to capitalize on the daily rebalancing mechanism. However, research from Credit Suisse reveals that the elevated trades in leveraged ETFs have followed the general end-of-day trends, and these vehicles have actually provided additional liquidity for trades. The last hour of U.S. stock trading this year has not been any more volatile than the rest of the day.
ProShares, a manager of leveraged ETFs, looked at volatility in a 2010 study that compared the standard deviations of the S&P 500 index constituents and a hypothetical 2x S&P 500 fund for every calendar year from 1999 to 2008. The study found that the hypothetical S&P 2x fund was less volatile than 39% of the components of the S&P 500 index, and the volatility in such a fund was comparable to a number of other non-leveraged ETFs.
Historical Causes Of Market Volatility
Historically, market volatility has been linked to macroeconomic uncertainty. Currently, the markets are experiencing wild swings because there's no clear outlook on the global economy, according to a Vanguard research note. Europe's financial instability, weakening data on the U.S. economy, the S&P's downgrade of U.S. debt and the possibility of a double-dip recession have all weighed on the markets and contributed to rising price risk, more so than the activity of investors or investment instruments.
Furthermore, other regional or single-country economic factors, including fiscal and monetary policies, will contribute to the changes in the market and volatility. Over the long term, inflation trends may influence stock markets and volatility. For instance, during times when inflation is falling or sits at low and stable levels, markets experience lower volatility and may trend higher.