Inverse ETFs in the Hot Seat

SATURDAY, AUGUST 17, 2013

Inverse ETFs in the Hot Seat

By BRENDAN CONWAY | MORE ARTICLES BY AUTHOR

Leveraged ETFs have a bad rap—as they should. But while they could be disastrous for your portfolio, they probably won’t damage the health of the market. Probably.

For individual investors, leveraged exchange-traded funds present a number of dangers, most prominently the chance to lose a lot of money very quickly. But are they dangerous to the health of the market, as well? These niche ETFs are built specifically for traders: They aren’t meant to be held, even overnight. If you own, say, a Direxion triple inverse Chinese-stock fund for more than a day, your investment moves in unpredictable directions, since the strategies used to create the leverage are reset every single day. So, if you hold one of these leveraged or inverse ETFs—and there are now some 250 of them—your return over time will bear little relation to the underlying index. It’s for this reason the Financial Industry Regulatory Authority has come down on the industry, and fined four big-name brokerages last year, for wrongly selling these ETFs to buy-and-hold clients.That danger should be easy enough to avoid: Just stay away from them.

But a Federal Reserve Board research paper, released last month, addressed a broader question: Do leveraged and inverse ETFs contribute to market volatility? They might, argued Fed economist Tugkan Tuzun, owing in part to a quality for which ETFs are usually lauded: their transparency. These ETFs are mechanical buyers and sellers of potent instruments, futures and swaps. They derive their leverage by buying and selling those contracts near the end of the trading session in an open, predictable manner that, Tuzun points out, tends to go in the same direction as the day’s market movement. That could make it easy for other quantitative systems to front-run and thus exaggerate the effect of that trading. The author’s key finding: The daily rebalancing of leveraged ETFs in late 2011 was equal to nearly 1% of all U.S. stock trading on days when indexes rose by 1%.

The author concluded that leveraged ETF rebalancing could be likened to 1980s portfolio insurance whose autopilot selling accelerated the 22% crash in the Dow Jones Industrial Average on Oct. 19, 1987. This has caused a stir among some fund watchers.

SHOULD YOU BE WORRIED? Certainly about market volatility, but probably not about these instruments. Leveraged ETFs are tiny versus the rest of the market. Their users tend to cash out when they succeed, so they don’t require as much rebalancing. What’s more, ETF moves are relatively small and usually swamped by other types of trading. Researchers who check whether late-session stock-index swings are linked to leveraged ETF rebalancing tend to find scant evidence for the broader market, with one academic calling it a “spurious coincidence.” But there appears to be a link for certain niches, such as small financial stocks, says Dave Nadig, head of ETF analytics at IndexUniverse. This jibes with the Fed’s finding of especially strong correlation in financial and technology stocks with ETF rebalancing.

It’s conceivable that leveraged ETFs could one day grow so large they have the effect identified in the Fed study. But it hasn’t happened yet—and other types of complex trading will surely get big enough first. As for the financial and technology sectors: Both have proven themselves perfectly capable of crashing before the leveraged ETFs made a splash.

About bambooinnovator
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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