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Leveraged ETFs are under fire for creating volatility in the stock markets, especially in the last hours of trading. The story goes that traders move through large positions in leveraged exchange-traded funds which then permeate through prices for individual securities.

The argument certainly has plenty of merit – leveraged funds do pass on volatility into small corners of the marketplace. However, it is important to note that all funds, not just levered funds, have this effect.

How Leveraged ETFs Work

Leveraged ETFs are usually set to double or even triple the daily change in the underlying index. If one were to purchase the Direxion Daily Financial Bull 3X Shares ETF (FAS), the investor would stand to earn or lose an amount equal to three times the change in the underlying financial securities contained in the index.

Naturally, ETF issuers and sponsors balance an ETF’s basket in a way that aligns with investment interest. If investors redeemed hundreds of thousands of leveraged ETF shares, the issuer must deliver the instruments used to mimic the underlying portfolio, or sell a proportional amount of the portfolio to deliver the cash equivalent.

Leveraged ETFs are more complicated than simple and straight-forward ETFs that do not provide for leveraging returns. However, this does not mean leveraged ETFs play a bigger part in volatility than any other exchange-traded fund.

Risk-on and Risk-off Trading Strategies

Exchange-traded funds of all types make the risk-on, and risk-off trades far more available to traders who might not otherwise have the opportunity to play the macro-market view. While I can afford to trade the SPY index as an individual, it is beyond my capacity to trade all 500 stocks in the S&P500 whenever I want to mimic the S&P500’s performance. The trading costs are simply too high.

Thanks to the exploding growth in ETF issuance and daily volume, I can trade the risk-on, risk-off trade as if I were an institutional firm through an ETF. This gives me access to the market in a way that I, as an individual, might never have enjoyed previously.

The risk-on, risk-off trade explained

Markets go through cycles spanning periods of several weeks and, in some cases, several months. During these periods, traders are usually either risk-on (buying more speculative investments like equity in fast-growing firms) or risk-off (buying boring blue-chip stocks or fixed-income investments like US treasuries.)

Global macroeconomics typically fuel risk appetite in the market. During the European banking fiasco, for example, traders took risk off the table, selling equity holdings in favor of safer stocks and bonds.

Traders and investors who held exchange-traded funds find the liquidity of exchange-traded funds to be valuable as a tool to reallocate assets. One could sell tens of millions of dollars in the SPY ETF in mere minutes, for example.

But that same volume and liquidity does not always exist in the equities that make up the SPY ETF. It certainly does not exist in all the stocks that make up the Russell 2000 Small Cap Index, or the exchange-traded funds that mimic the index’s performance, like the iShares Russell 2000 (IWM) or the leveraged variety, Direxion Daily Small Cap Bull 3x Shares (TNA).

Efficiently Inefficient Markets

Exchange-traded funds, leveraged or straight ETFs, are wildly liquid to a level never before seen in the financial markets. However, companies that make up the indexes can be horrendously illiquid. It took me mere moments to find one stock, Aceto Corp (ACET), which sees average daily volume of less than 100,000 shares at a share price of just under $8 per share.

You simply cannot move large amounts of money in and out of Aceto Corp very quickly. You can move in and out of the Russell 2000 Index very easily – almost too easily! Any creation or redemption of Russell 2000 Index ETF shares require a transfer of Aceto Corp stock from one entity to another.

The disconnect between the volume for ETF “packages” of stocks and the volume for individual stocks creates frictional volatility. A lack of liquidity in individual equities is neither good nor bad; it’s a function of a marketplace that works quite well. Furthermore, volatility is the friend of both the buyer and seller; it allows for investors to sell for a higher price to ETF traders, and buyers an opportunity to purchase at a discount created by ETF sellers.

When the risk-on, risk-off trade becomes most active, these small cap stocks are the most wildly affected as they are mostly illiquid, and also considered to be at the forefront of risk appetite or avoidance. One would typically sell small caps to take risk off the table, and purchase small caps to insert risk back into a well-balanced portfolio.

For examples of exploiting market inefficiencies, see these examples of gold pairs trades, silver pairs trades, and this strange market timing phenomena.

The bottom line: If it isn’t broken, don’t fix it. Exchange-traded funds do enable and make more visible the volatility in the marketplace. But don’t blame the messenger – ETFs pass on the volatility from another source. To blame ETFs for market volatility in recent months would be to give a pass to the European Union’s many budget problems, which simply are not a by-product of ETF trading on a financial market 5,000 miles away from European shores.

Source: Do Leveraged ETFs Create Volatility? No - All ETFs Do