Fed Warns Leveraged ETFs Could Trigger 1987-Style “Cascade” In Stocks

August 13, 2013 Leave a comment

Fed Warns Leveraged ETFs Could Trigger 1987-Style “Cascade” In Stocks

Tyler Durden on 08/12/2013 10:41 -0400

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In a 43-page research report, the Federal Reserve has authored a rather concerning tome warning that the mechanical positive-feedback rebalancing of Leverage ETFs (LETFs) resembles the portfolio insurance strategies, which contributed to the stock market crash of October 19, 1987. The impact of LETFs on broad stock-market indexes become significant during periods of high volatility (shown empirically in 2008/9 and H2 2011) as they show that LETF rebalancing in response to a large market move could amplify the move and force them to further rebalance which may trigger a “cascade” reaction. Furthermore, executing orders within a short period of time, such as the last hour of trading, may cause disproportionate price changes (especially in financial stocks). The Fed warns that a significant price reduction at market close may also impair investor confidence with accelerating depressed prices at the close potentially driving large investor outflows overnight.ETF-rebalancing implied price effects are most egregious at times of stress…

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ETF rebalancing flows have grown dramatically…

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BUT – what is most concerning is that LETF rebalancing flows as a fraction of stock volume in the last hour is surging – especially for small-caps…

The frequency of a large price move in the last hour of trading is zero until 2007 when the first financial LETF is launched. Consistent with the implied price impact results, the frequency of a large price move is elevated when the price volatility is high, reaching 0.8 in the 2008-2009 financial crisis and 0.6 in the second half of 2011. These results, combined with the implied price impact estimates, suggest that LETF rebalancing contributed to the stock market volatility in the 2008-2009 financial crisis and in the second half of 2011.

Filed under Macro Trends

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Kee Koon Boon (“KB”) is the co-founder and director of HERO Investment Management which provides specialized fund management and investment advisory services to the ARCHEA Asia HERO Innovators Fund (www.heroinnovator.com), the only Asian SMID-cap tech-focused fund in the industry. KB is an internationally featured investor rooted in the principles of value investing for over a decade as a fund manager and analyst in the Asian capital markets who started his career at a boutique hedge fund in Singapore where he was with the firm since 2002 and was also part of the core investment committee in significantly outperforming the index in the 10-year-plus-old flagship Asian fund. He was also the portfolio manager for Asia-Pacific equities at Korea’s largest mutual fund company. Prior to setting up the H.E.R.O. Innovators Fund, KB was the Chief Investment Officer & CEO of a Singapore Registered Fund Management Company (RFMC) where he is responsible for listed Asian equity investments. KB had taught accounting at the Singapore Management University (SMU) as a faculty member and also pioneered the 15-week course on Accounting Fraud in Asia as an official module at SMU. KB remains grateful and honored to be invited by Singapore’s financial regulator Monetary Authority of Singapore (MAS) to present to their top management team about implementing a world’s first fact-based forward-looking fraud detection framework to bring about benefits for the capital markets in Singapore and for the public and investment community. KB also served the community in sharing his insights in writing articles about value investing and corporate governance in the media that include Business Times, Straits Times, Jakarta Post, Manual of Ideas, Investopedia, TedXWallStreet. He had also presented in top investment, banking and finance conferences in America, Italy, Sydney, Cape Town, HK, China. He has trained CEOs, entrepreneurs, CFOs, management executives in business strategy & business model innovation in Singapore, HK and China.

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