Leveraged ETFs: New Source of Systemic Risk 24 comments
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Very interesting new research paper out from Barclays Global detailing some of the consequences and risks flowing from the growth in assets under management at leveraged ETFS (i.e., those funds that try to produce anywhere from -3x to +3x the return of a particular benchmark on a daily basis). Here is a snippet that caught my eye in particular:
Inverse ETFs in particular have a magnified hedging demand relative to their long counterparts (e.g., as shown above, a 2x inverse ETF has the same hedging multiplier as a 3 leveraged long ETF) The analysis above shows leveraged and inverse ETFs amplify the market impact of all flows, irrespective of source. Essentially, these products require managers to "short gamma" by trading in the same direction as the market. There is a close analogy to the role played by portfolio insurance in the crash of 1987. The magnitude of the potential impact is proportional to the amount of assets gathered by these ETFs, the leveraged multiple promised, and the underlying index's daily returns.
In short, leveraged ETFs, as assets increase, represent a new source of systemic risk in the market as their managers rebalance them at market close every day.
Source:
The Dynamics of Leveraged and Inverse Exchange-Traded Funds
Minder Cheng and Ananth Madhavan
Barclays Global Investors
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This article has 24 comments:
That's why I endorse leveraged ETFs as being helpful to the retail investor. It's another way to escape the middle income trap and advance. If you are going to put your pension dollars in the market and forget about them, you may as well put them in a 2x ETF fund.
You increase your volatility, while the market risk is always there and is the same.
To say these create market-wide systemic risk is absurd. In that case, throw all the institutional quants out on the street yesterday- their effects are orders of magnitude higher on the overall markets. Leveraged ETFs actually give the little guy a chance to have skin in the game- albeit skin he can very easily lose. Whatever happened to caveat emptor?
These funds are for daily trading only, they do not track the indices. Their positions are liquidated on a daily basis. They will trend with the market on a daily basis but will wildly deviate from it in any time period longer than that.
To the author, I agree with your conclusion that these funds present risk, especially when given to John Doe (^ nudge nudge). We have all seen how much damage can be done to any economy when everyone and their brother is a real estate broker/ house flipper.
Now everyone wants to play hedge fund like market plays and profit from a system riddled with volatility. Leveraged retail instruments begin to tread into that territory.
This is where I start to ramble...
Its my belief that the concept of ETF's, as they grow in popularity, will begin to present systemic risk. You have highly liquid shares being traded which are only being physically backed by trust in the issuer. Exponentially amplify SLV and GLV and the distrust that comes with them and you have the risk I am seeing.
I understand that this sounds cynical but given the abuses greed brings I wouldn't put it past a few to be trading on the reputation of their ETF keeping pace with the portfolio.
On Apr 20 02:04 PM MarkitWacha wrote:
> If what you say is true, then this assumed risk is underpriced. In
> other words, it's cheap for the retail investor. It's a bargain for
> bargain hunters.
>
> That's why I endorse leveraged ETFs as being helpful to the retail
> investor. It's another way to escape the middle income trap and advance.
> If you are going to put your pension dollars in the market and forget
> about them, you may as well put them in a 2x ETF fund.
>
> You increase your volatility, while the market risk is always there
> and is the same.
>
on the flip side down days will end in puking fests. let's see what happens today. SKF SEF above average volume. IYF below avg.
On Apr 20 02:04 PM MarkitWacha wrote:
> If what you say is true, then this assumed risk is underpriced.
> In other words, it's cheap for the retail investor. It's a bargain
> for bargain hunters.
>
> That's why I endorse leveraged ETFs as being helpful to the retail
> investor. It's another way to escape the middle income trap and
> advance. If you are going to put your pension dollars in the market
> and forget about them, you may as well put them in a 2x ETF fund.
>
>
> You increase your volatility, while the market risk is always there
> and is the same.
>
On Apr 20 02:47 PM Whippet wrote:
> Jolly Rancher- I take it that you would agree with the statement
> that "the gun killed the man, not the shooter." Leveraged ETFs,
> used properly, are a wonderful way to hedge risk or pick up swings
> on a short term basis. Especially as a short element of IRAs- you
> could have watched your retirement savings grow instead of helplessly
> deteriorate if you hedged properly with these instruments. The constant
> leverage trap takes care of fools who use them as buy and hold investments.
> Margin laws regard using leverage to buy/sell stock positions; no
> more, no less. These instruments use options, futures, and margin
> to create vehicles that legally perform a specific function.
>
> To say these create market-wide systemic risk is absurd. In that
> case, throw all the institutional quants out on the street yesterday-
> their effects are orders of magnitude higher on the overall markets.
> Leveraged ETFs actually give the little guy a chance to have skin
> in the game- albeit skin he can very easily lose. Whatever happened
> to caveat emptor?
On Apr 20 02:36 PM Jolly_Rancher wrote:
> Leveraged ETFs look to me like a very clear attempt to circumvent
> margin laws that were enacted for a reason. Does this kind of crapola
> sound familiar? They should be shut down immediately. It's just another
> way for compulsive market hyper traders to lose their money and everyone
> else's.
The ETFs are not suitable for all investors and should be utilized only by sophisticated investors who understand leverage risk, consequences of seeking daily leveraged investment results and intend to actively monitor and manage their investments.
The risks associated with the funds are detailed in the prospectus which include.
adverse market condition risk,
adviser's investment strategy risk,
aggressive investment techniques risk,
counterparty risk,
credit risk,
daily correlation risk,
daily rebalancing and market volatility risk,
interest rate risk,
inverse correlation risk,
leverage risk,
market risk,
non-diversification risk,
Shorting risk,
tracking error risk,
debt instrument risk,
regulatory risk,
gain limitation risk,
U.S. government securities risk,
and special risks of exchange-traded funds.
more here: moneyneversleepsblog.b...
On Apr 20 02:47 PM Whippet wrote:
> Jolly Rancher- I take it that you would agree with the statement
> that "the gun killed the man, not the shooter." Leveraged ETFs, used
> properly, are a wonderful way to hedge risk or pick up swings on
> a short term basis. Especially as a short element of IRAs- you could
> have watched your retirement savings grow instead of helplessly deteriorate
> if you hedged properly with these instruments. The constant leverage
> trap takes care of fools who use them as buy and hold investments.
> Margin laws regard using leverage to buy/sell stock positions; no
> more, no less. These instruments use options, futures, and margin
> to create vehicles that legally perform a specific function.
>
> To say these create market-wide systemic risk is absurd. In that
> case, throw all the institutional quants out on the street yesterday-
> their effects are orders of magnitude higher on the overall markets.
> Leveraged ETFs actually give the little guy a chance to have skin
> in the game- albeit skin he can very easily lose. Whatever happened
> to caveat emptor?
As mentioned, leveraged ETFs work well when used properly, but that's their problem. They are too effective, yet most people don't seem to be using them properly.
The problem is when they go so mainstream that the sharks get involved and create a risk across the system. When your dentist starts telling you how he made a bunch of cash using UYG or FAS, then it's time to start worrying.
And for the gun analogy someone made, you would want someone owning a firearm to have a license and training for it right? Train yourself at home doesn't count either.
I'm not saying do away with the products, but they have the potential to be extremely dangerous.
People sometimes need protection from themselves. That's why we have traffic lights and crosswalks.
On Apr 20 03:38 PM ETFtrader wrote:
> Heaven forbid anyone other than the big players should be allowed
> to play the market the way these ETFs allow the individual investor
> to. By your reasoning, day traders and swing traders, etc. who invest
> in these ETFs are like children who should not be allowed to cross
> the street unless escorted by a responsible adult. How ridiculous.
> Let's not forget whose money the big boys are playing with, and don't
> insinuate that individual investors lack the common sense to decide
> what to do with their money. I think most of us have more investing
> acumen than you would give us credit for.
For me, this and the chase against shorting is nothing more than an engineered witch hunt, since retail investors are incapable of moving the markets. There are a lot of instruments of destruction out there and I think leveraged etfs are somewhere in between. Why can't the regulators start doing their job properly and stop fidgeting with the blame game?
Don't be surprised to see them come out with a 'safe' version.
They also allow some very interesting arbitrage opportunities.
Bad side is that traditional traders who use non-leveraged stocks, except for 3x margin accounts, are being attracted to xETF. Neophyte traders will burn out faster with xETF than with playing with ordinary stocks and index trackers such as SPY, DIA, QQQQ, etc. More traders wanting to gain experience through time will burn out faster than they should without xETF.
As for investors:
xETF has a compounding effect that will be very beneficial in the long-term basis since they are being compounded in the daily basis. Enhanced compounding works better to the upside than to the downside (see my previous posts on effects of compounding to upside/downside by xETFs).
Also, xETFs maybe less risky than picking individual stocks assuming the managers of those funds do their due diligence evaluating companies balance sheets - thus relieving many small investors of trying to analyze company fundamentals. They simply don't have the resources nor the time needed to do such a gargantuan task on small capital.
Only problem is the risk of counterparties for leveraged ETF since they will have to borrow the margin for the leverage.
The question is at what level will their counterparties withdraw their credit if an xETF goes into trouble such as if the xETF goes drastically down to almost zero due to the enhanced compounding effect to the downside?
On Apr 20 02:04 PM MarkitWacha wrote:
> If what you say is true, then this assumed risk is underpriced.
> In other words, it's cheap for the retail investor. It's a bargain
> for bargain hunters.
>
> That's why I endorse leveraged ETFs as being helpful to the retail
> investor. It's another way to escape the middle income trap and
> advance. If you are going to put your pension dollars in the market
> and forget about them, you may as well put them in a 2x ETF fund.
>
>
> You increase your volatility, while the market risk is always there
> and is the same.
>
I don't advocate or personally use 3x ETFs as investments- I use them as hedges and swing trades. Wouldn't it have been nice to hedge long positions in C, BAC, and WFC with out of the money calls on FAZ? But you would require me to have permission from the Washington illuminati, or some sort of BS certification.
Our padded cell society will have us all asking "Who is John Galt?" by 2020 at the current clip.
>Too much leverage is what created the world Ponzi economy and brought it crashing down. Leveraged ETF's should be either be outlawed or offered only by casinos. Casinos could offer a 100 to 1 leveraged ETF for example (why fool around with a 3X leveraged ETF). But, the stock market should be restricted to responsible investment instruments. <