By Tim Dulaney, PhD and Tim Husson, PhD
Leveraged exchange-traded funds (LETFs) are controversial investments. Because they can be leveraged as much as 3x, and can be linked to highly volatile underlying assets, their daily price movement is typically very dramatic. Also, LETFs tend to lose value over time if their underlying assets are relatively volatile due to rebalancing effects, something we've covered here before as well as in our research papers (PDFs).
Another concern with LETFs is that they could increase the volatility of their underlying assets. To see how, consider how a typical LETF achieves its leverage. If its assets increase in value over the course of a day, the LETF has to purchase more of those assets in order to keep its leverage ratio (2x, 3x, etc.) constant. If those assets decrease in value, the LETF has to sell some assets for the same reason. The concern is that if LETFs attract significant assets, these rebalancing transactions could create a positive feedback loop of increased buying in rising markets and increased selling in downward-trending markets.
Recent research from the Federal Reserve (PDF) suggests that just this situation could occur and could have a large effect in the stock market. In fact, the paper argues that LETFs "contributed to the stock market volatility in the 2008-2009 financial crisis and in the second half of 2011 when the European sovereign debt crisis came to the forefront." The paper also notes that because LETFs must rebalance every day, that their trading activity "is predictable and may attract anticipatory trading." This could also exacerbate the positive feedback loop, leading rising stocks higher and falling stocks lower, as we have discussed before.
Interestingly, the paper compares LETFs to 'portfolio insurance strategies' of the late 1980s. Portfolio insurance is a hedging technique that also effectively requires purchasing assets in rising markets and selling in falling markets. It is thought to have contributed to the stock market crash of Black Monday (October 19, 1987), when the Dow Jones lost almost a quarter of its value in a single day.
While equity LETFs currently may not be a particularly large fraction of stock market trading, as LETFs expand to other, less liquid asset classes, these rebalancing effects could become more pronounced. Also, not everyone agrees about the effects of LETF rebalancing. Unfortunately, we may have to wait for a particularly grim day on Wall Street to truly test this effect.
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