New Research: Leveraged ETFs Do Make Markets Volatile
New paper shows rebalancing a problem at end of day for real estate sector stocks.
March 25, 2015
A few years ago, everyone was jumping on leveraged and inverse exchange-traded funds (ETFs) as the cause of extreme market volatility—particularly during the last minutes of the trading day. At the frontline of this argument was New York Times writer Andrew Ross Sorkin who argued in his column that leveraged and inverse ETFs, which have to rebalance at the end of every day, are the probable cause of extreme market volatility at that time.
Since then, a lot of time and resources have been spent trying to get to the bottom of this phenomenon—after all, no one wants another flash crash. The most recent research-based conclusion is that no, leveraged and inverse ETFs don’t cause market volatility because capital flows essentially increase or decrease rebalancing demand. In other words, it all washes out in the end.
Fair enough, but now a team of academics has come up with new evidence that perhaps leveraged and inverse ETFs do ramp up end-of-day volatility—and that the effects can be detrimental to investors.
The paper “The Impact of Leveraged and Inverse ETFs on Underlying Real Estate Returns” is published in the latest issue of Real Estate Economics. Researchers Qing Bai, Shaun A. Bond and Brian Hatch explain that the construction of leveraged and inverse ETFs makes them particularly problematic from a rebalancing standpoint: as they seek to match returns of double or triple the daily return of the underlying index (on the up or downside) they rely not just on holdings of the index constituents and cash but on futures and swaps as well.
The authors use ProShares (one of the largest providers of leveraged and inverse ETFs) as an example of how a product is built: for a 2x S&P500 leveraged ETF, 85% is invested in the S&P500 stocks, with the remainder in cash. However, they also purchase S&P500 futures to increase the S&P 500 exposure to 110% and, finally, enter into long equity index swaps to achieve the target exposure of 200%.
All that is rebalanced daily. That’s a lot of activity—and it could lead to pressure on prices of component stocks, particularly as leveraged or inverse ETFs rebalance in the same direction.
But doesn’t it all even out in the end due to fund flows, as the previous research points out? Not necessarily.
Bai, Bond and Hatch focus on the real estate sector, which some believe is particularly vulnerable. Using the Dow Jones U.S. Real Estate Index, the team does indeed find that component stocks experience increased volatility, increased trading activity and increased continuation of returns/momentum. Such findings support the claims that leveraged ETFs do affect markets when they rebalance. But it might correct itself early the next day—and that’s important for investors to know.
As the authors write:
The greater the rebalancing buying (selling) activity the larger
(smaller) the returns in the component stock. Not surprisingly, we also find that
the magnitude of absolute rebalancing demand is directly related to component stock volatility.
As the authors find, leveraged ETF-related trading causes “prices overshooting and volatility” late in the day (between 3 p.m. and 4 p.m.) for smaller, volatile real estate sector stocks. That overshooting tends to be reversed in the first house of the next day.
What affect can this have on investors? As the authors write, on days that real estate sector volatility is high, the size of the impact on a typical stock during that 3 p.m. to 4 p.m. time can be 234 basis points and can swing as high as 327 basis points.
You can download the paper here. Meantime, the debate over the market impact of leveraged and inverse ETFs appears to be open—for investors, particularly in the real estate sector, it could mean added caution during volatile times. And an understanding that, while late-day volatility might be put to rest in the early hours of the next trading day, it’s something investors might need to be aware of as they make their trading decisions.