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.

According to Vanguard's research, the S&P 500 index experienced an average 2.5% move, either up or down, every day through August following the U.S. debt downgrade. ETF trading volumes also spiked during this bout of market volatility.

Vanguard, though, argues that volatility, on average, should have been shifting upward over time if the rise in overall market volatility were the direct result of changes by market participants. However, data does not show any historical upward shifts in volatility levels-volatility remained stable and low before S&P's August 5 downgrade of the U.S., but jumped after significant global macroeconomic distress appeared. Vanguard emphasized that the recent market fluctuations were ordinary during past periods of similar uncertainty.

Understanding Leveraged ETFs
ProShares launched the first set of leveraged ETFs back in June 2006. The funds used equities and other financial products, including derivatives such as options and futures contracts, to mimic leveraged returns.

Since trading an ETF is a quick and easy method of investing, ETF investors who seek additional exposure to specific areas of the market may benefit from the leverage strategy instead of relying on options, futures or margins. Leveraged ETFs may help investors capture short-term gains and hedge current positions in portfolios, and they can also be used in a pairs trading strategy.

ETFs that offer a leveraged strategy rebalance regularly to achieve their intended leverage targets. Most leveraged ETFs adhere to a daily reset, and as a result of the daily rebalancing, the multiple-day return will not perfectly reflect a 2x or 3x performance of the underlying index. Because of compounding, leveraged ETFs show deviations from their net asset values over the long term as the funds adhere to their regular rebalancing. Additionally, the daily reset ETFs may underperform during highly volatile situations and outperform in times of low volatility.

Some other leveraged products do not reset every day but may reset after a certain number of days. The ETFs will try to reflect the stated leverage at trade multiplied by the total return of the underlying benchmark: A fund might reflect two times or three times the performance of an underlying benchmark over a certain period. For instance, some leveraged ETFs will rebalance holdings monthly. 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.

Leveraged Fund Providers
ProShares is the largest provider of leveraged ETFs. It offers leveraged funds that cover most of the largest asset classes, sectors and sub-sectors. Direxion also offers a large suite of leveraged funds that cover U.S. and global equities, along with some Treasury bonds.

ETRACS offers a few leveraged exchange-traded notes.

FactorShares offers some unique strategies on leveraged long/short ETFs that hold a leveraged long position in one asset and short the assets of another, which helps the funds capitalize on the spread between the two assets.

Invesco PowerShares has issued a couple of leveraged Treasury-related ETNs.

Rydex has a leveraged/inverse S&P 500 ETF.

VelocityShares provides leveraged short- and medium-term VIX ETFs.

Tom Lydon is editor and publisher of ETF Trends, a Web site with daily news and commentary about the fast-changing trends in the exchange-traded fund (ETF) industry. Lydon is also president of Global Trends Investments, an investment advisory firm specializing in the creation of customized portfolios for high-net-worth individuals. Disclosure: At the time of publishing, Mr. Lydon's clients owned IndexIQ Agribusiness Small Cap ETF (NYSEArca: CROP).
Read the disclaimer; Tom Lydon is a board member of Rydex|SGI.