Tuesday, October 22, 2013

Just How Risky Are Leveraged and Inverse ETFs?

By Tim Dulaney, PhD, FRM and Tim Husson, PhD

Leveraged and inverse exchange-traded funds (ETFs) are some of the most volatile securities traded in public markets.  They are designed to track a specific index, except multiplying daily return of the index by a positive (leveraged) or negative (inverse leveraged) factor.  The 'daily' part is important:  leveraged and inverse ETFs do not track the leveraged or inverse return of the index for any period longer than a single day due to portfolio rebalancing.  You can find more details about rebalancing risk in our review paper on the subject.

Despite these risks, leveraged and inverse ETFs continue to attract assets, sparking a robust debate about their potential impact on the broader market.  One of the most hotly debated topics is whether ETF rebalancing causes distortions in market prices.  Because of the way leveraged ETFs rebalance, they tend to purchase more of their underlying assets in rising markets and sell in down markets.  If these purchases or sales are relatively large trades, this could push rising prices higher and falling prices lower, effectively increasing daily volatility of the underlying assets.

Whether or not leveraged ETF rebalancing has an impact on market prices has been debated now for several years.  The issue was highlighted in three papers released in April 2011, one from the Bank of International Settlements (PDF), one from the Financial Stability Board (PDF), and one from the International Monetary Fund (PDF).  These papers argued that the growth of ETFs could lead to market disruptions due to a variety of factors.  These and other papers led to some significant media attention, as well as some rebuttals.  Earlier this year, a paper from the Federal Reserve (PDF) argued more specifically that leveraged ETF rebalancing could lead to increased volatility, similar to the infamous portfolio insurance of the late 1980s.  This paper triggered a lively debate, summarized in a recent article at Risk.net.

It is important to recognize that regardless of whether leveraged and inverse ETFs have a broader effect on markets, that they are highly risky to individual investors is not controversial.  Most sources, including the issuers themselves, agree that leveraged and inverse ETFs are designed for traders and are not suitable for investors.  And yet, we know from firsthand experience that long-term investors are being sold these products, suggesting that many brokers and advisers do not understand their inherent risks.

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