“Modern investors are very different from those of yesteryear; volatility for them isn’t exactly a source of fear, but an opportunity.” © Trading Places

Most ETFs are big, broad, boring and cheap beta. But there’s now probably close to $200bn in leveraged and inverse ETFs, and their market impact is growing.

Leveraged and inverse ETFs use derivatives and margin loans to either deliver extra juice to investors — say, three times the daily return of the underlying index — or the opposite of what the index does.

“Good” examples are things like TQQQ, the $20bn triple-leveraged Nasdaq ETF; TMF, a three-times leveraged Treasury bond ETF with $2.5bn in assets, and the $90mn SOXS, which delivers three times the losses of semiconductor shares. There are even single-name leveraged ETFs. It’s basically all gone a bit mad.

Interestingly, even the Bank of England’s capital markets division now seems to be taking a closer look at the phenomenon — and the potential market implications.

The central bank’s Bank Underground blog has just published a post by former derivatives trader turned gamekeeper Julian Oakland (who this month seems to have joined ADG as head of risk) that examines the market dynamics around leveraged ETFs.

Here is the intro, with Alphaville’s emphasis below:

Exchange-traded funds (ETFs) are supposed to be simple and straightforward, and for the most part they are, but one group punches well above its weight when it comes to market impact. In this post, I show that leveraged and inverse (L&I) ETFs generate rebalancing flows that: (1) are always in the same direction of the underlying market move; (2) grow significantly with both increasing and inverse leverage; and (3) must be transacted towards the end of the trading day. These features give rebalancing flows the potential to amplify market moves when markets are at their most vulnerable. L&I ETFs do not currently pose a risk to UK financial stability, but this could change if they grow in popularity.

The post does a good job of unpicking how leveraged and inverse ETFs function, and especially how they are an inherently procyclical force, reinforcing both rallies and sell-offs.

As Oakland points out, they’re not particularly significant in the UK stock market, so worries about their impact there are premature. But as the post caveats, that could change.

And they ARE a force to be reckoned with in the US market, as the post explains (Alphaville’s emphasis below):

On 13 September 2022, equity markets had their largest sell-off since 2020, with the Nasdaq 100 down 5.2% and the S&P 500 down 4.3%. Using ETF fund data from etfdb.com and equity market data from www.cboe.com, I calculated rebalancing flows for all US equity L&I ETFs on this day to be just over US$20 billion of equities sold, representing around 3.8% of the total value of all S&P 500 shares traded (or the equivalent of just over 100,000 E-mini S&P 500 futures — as an old futures and options trader, these numbers made me gulp!). 

Gulp indeed.

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