Leveraged Exchange Traded Funds have become a significant factor in the U.S. equity market. According to a new Federal Reserve discussion paper their mechanical rebalancing rules can reinforce or even escalate large directional moves in the stock market, both through their own transactions and other market participants’ front running.
“Are Leveraged and Inverse ETFs the New Portfolio Insurers?”, Tugkan Tuzun
The Federal Reserve Board – Finance and Economics Discussion Series, 2013-48
The below are excerpts from the paper. Emphasis have been added.
The main features of leveraged and inverse ETFs
“Leveraged and Inverse Exchange Traded Funds (LETFs) are exchange-traded products that typically promise multiples of daily index returns. Generating multiples of daily index returns gives rise to two important characteristics…
- LETFs rebalance their portfolios daily by trading in the same direction as the changes in the underlying index, buying when the index increases and selling when the index decreases… both Inverse and Leveraged ETFs rebalance in the same direction as their target indexes and their rebalancing do not cancel each other out…Furthermore, this formula is a function of only the target index change, not its level, making LETF rebalancing insensitive to the price level.
- This rebalancing requirement of LETFs is predictable and may attract anticipatory trading.”
“LETFs do not have to directly trade in the stock market to rebalance their portfolios…Anecdotal evidence suggests that LETFs commonly use swaps and futures contracts to rebalance their portfolios. Swap counterparties of LETFs are likely to hedge their positions in equity spot or futures markets. If LETFs use index futures, index arbitrageurs transfer the price pressure from the futures market to the stock market.”
The market impact of rebalancing
“The size of LETF rebalancing demand varies with their net assets and the multiples of daily index return they promise. Based on total net asset value of USD20.14 billion as of December 15, 2011, when broad stock-market indexes change by 1%, LETFs rebalancing demand totals USD1.04 billion worth of stock. This is roughly 0.84% of daily stock-market volume (excluding the volume of the ETFs and the Depository Receipts) in the United States… the Flash Crash of May 6, 2010 was triggered by a USD4.1 billion (75,000 contracts of E-Mini S&P 500 Futures) sell order, which is equivalent to only 3% of the E-Mini S&P 500 Futures daily volume… With a large market move, such as 4%, the total rebalancing flows of LETFs would be equivalent to this “Flash Crash” order.”
“LETF rebalancing is an important fraction of daily volume, especially in financial and small stocks. For instance, if the Russell 1000 Financial Services Index increases by 1%, the rebalancing demand of LETFs totals roughly 2% of the daily volume for an average financial stock.”
“LETFs rebalance their portfolio in the last hour of trading. Therefore, a large market move could make these stocks vulnerable near the market close, or even before to the extent that opportunistic traders react in anticipation of subsequent LETF rebalancing… LETF rebalancing in the last hour of trading leads to price reaction and extra volatility in all stock categories. For instance, if the S&P 500 index goes up by 1%, LETF rebalancing demand results in a 6.9 basis-point increase in price and a 22.7 basis-point increase in daily volatility in an average large-cap stock.”
“The implied price impact of LETF rebalancing on financial markets was notable especially during the financial crisis of 2008- 2009 and at the height of the European sovereign debt crisis. If LETF rebalancing exerts significant price pressure, this price pressure could amplify the market movements. Although LETFs have not been proven to disrupt stock markets, it is plausible that during periods of high volatility, their impact in response to a large market move could reach a tipping point for a “cascade” reaction.”