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Barclays Report: Are Leveraged ETFs Creating Systemic Risk?

If some of the new highly leveraged ETFs issued are on crack, what does it mean for the rest of the (non-drug-abusing) market? Barclays Global Investors analyst Ananth Madhavan has written a report arguing that the effects of leveraged ETFs on the markets have been underestimated by most analysts. Jason Zweig has a nice writeup at The Wall Street Journal. Clearly leveraged ETFs have created some extra volatility in the markets, especially in the late afternoon. But have they created systemic risk?

The article explains how the the leveraged ETFs’ daily behavior can affect volatility towards the end of the day:

Now let’s say the fund’s net assets grow by $10 million during the day, to $110 million. The fund must raise its swap exposure from $200 million to $220 million to honor its 2-for-1 investment objective. That is $20 million in extra buy orders, all coming into the market after 3:30 p.m., typically in the final 10 minutes.

Further, hedge funds and other large investors will trade just ahead of the leveraged ETFs’ after-3:30 trades, in anticipation of them. This amplifies the effect of the leveraged ETFs’ daily trades on the price of securities.

Phil Mackintosh, of Credit Suisse, argues with Mr. Madhavan’s conclusions, and is quoted in the article saying that leveraged ETFs typically account for “less than 4% of total trading in the last hour.” So, at this point, it’s enough to move the needle, but probably not enough to change the game. But if assets continue to pour into leveraged ETFs, the effects could be much more dramatic.

Disclosure: At the date of publishing, the author currently does not own any shares of the specific stocks mentioned.