A research paper submitted to the Finance and Economics Discussion Series, part of the Federal Reserve’s Division of Research & Statistics and Monetary Affairs, on inverse and leveraged ETFs has created some controversy.
The paper, “Are Leveraged and Inverse ETFs the New Portfolio Insurers?,” was submitted by Tugkan Tuzun and submitted in July. One of the paper’s key points is that inverse and leveraged ETFs are similar to the portfolio insurance products that some market observers believe prompted the 1987 market crash. The paper also contends that the daily rebalancing associated with inverse and leveraged ETFs could potentially cause future market crashes.
Those assertions earned a stark rebuttal from Boost ETP, a boutique firm that specializes in European short and leveraged ETFs.
“First of all ETFs are essentially market access tools. They do not invent trading or investment strategies, but rather just give investors tools to use to express them. S&L ETFs also sit alongside many types of leveraged trading vehicles including prime brokerage accounts, futures, options, structured products, margin trading OTC derivatives, CFDs/Spread Bets, covered warrants and so on. Interestingly the leverage factor employed by S&L ETFs is usually 2 or 3x the return of the index. This is an extremely low leverage compared to the leverage employed by some of the instruments listed above which can be up to 20 times,” said Boost ETP.
The firm also notes that inverse and leveraged ETFs also account for a scant percentage of overall ETF assets, a point confirmed by other sources. Of the $1.53 trillion in US ETF assets under management, leveraged and inverse funds make up 2.3%, according to BlackRock.
Inflows to short and leveraged ETFs comprise less than 5% of total year-to-date ETF inflows, though flows have picked up over the past month in what could be a sign investors are expecting and looking to profit from a market pullback. [Leveraged ETFs Buck Recent Outflows Trend]
Boost also rebuts the notion that end-of-day activity related to leveraged ETFs can lead to crashes. “There is a huge amount of activity at the close and in the closing auctions on the various global exchanges. This is of course for a variety of investment and trading strategies. If anything, the close on an exchange is the point of the day when liquidity is highest and where leveraged ETF rebalancing is least likely to have an impact,” the firm said.
Boost noted that in 2011, Credit Suisse published a paper leveraged ETF rebalancing is “unlikely to be the most influential factor in driving intraday swings into the close.” Hector McNeil, co-CEO of Boost, went so far as to say the Fed paper is “a head-line grabber.”
Popular leveraged ETFs listed in the U.S. include the ProShares UltraShort Financials (NYSEArca: SKF) and the Direxion Daily 20+ Year Treasury Bear 3X Shares (NYSEArca: TMV).
ProShares UltraShort Financials
ETF Trends editorial team contributed to this post.