The problem with leveraged ETFs is that the losses from daily rebalancing are not easy to quantify. They’re dependent on volatility: the more volatile the underlying index, the more quickly the ETF will “decay.” But there is also autocorrelation risk, meaning there is compounding when the underlying index is up or down several days in a row. The ETFs have taken in $72 billion in new cash since 2006, according to Bloomberg Intelligence, yet their level of assets has stayed about the same because they tend to burn through money in the long term due to the daily resetting of leverage.
Leveraged ETFs are also path dependent in ways that most financial instruments are not. In fact, they’re one of the most complicated derivatives imaginable, especially when you have leveraged ETFs on things like volatility, but they’re easier for retail investors to access than either futures or options.
While retail investors were slow to pick up on the daily rebalancing feature, the quants were not, and what ensued was a giant transfer of wealth from retail investors to professional investors. Professional investors figured out that you could be short leveraged ETFs and actually benefit from the effects of the daily rebalancing. Look, the whole point of Wall Street is to have a transfer of wealth from the unsophisticated to the sophisticated. There is nothing un-American about that. But this is egregious. New York Attorney General Eric Schneiderman went after the daily fantasy sports providers, in part, on the same grounds—the pros were fleecing the punters. It was considered to be excessive. To be fair, the Securities and Exchange Commission did freeze new approvals after warnings from the likes of BlackRock Inc.’s Laurence Fink and Wall Street’s brokerage regulator, the Financial Industry Regulatory Authority.
I was running the ETF desk at Lehman Brothers around 2006 when one of the issuers came by the trading floor to convince us to be authorized participants for the first leveraged ETFs. I saw how these things worked and asked myself, “Are these guys nuts?” Too bad the regulators didn’t feel the same way back then. It's tough to put the genie back in the bottle, but if one were to have perfect knowledge of what was about to happen next, I think the SEC would like to have this one back.
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This article was provided by Bloomberg News.