Are Leveraged ETFs Driving Market Volatility?

Believe it or not, there are some people involved in the investment industry who are against Exchange Traded Funds (ETFs). ETFs provide transparent exposure to a wide range of global markets at a low cost. ETFs have allowed us to gain access to return streams many didn’t have access to just a decade ago. For example, if you want to trade Silver, you can now get that exposure with an ETF (SLV). Previously, you would have to buy actual silver bars and deal with them. Or, trade silver actual futures or options. There is nothing wrong with trading the options and futures, but it sure is simpler to get exposure to that return stream with an ETF in many types of accounts. I monitor 25 different countries in my universe that we can access through ETFs. When I started developing my quantitative trend systems in 2001 to 2003 I decided to apply them to sector and country ETFs instead of futures as most others did at the time. ETFs have changed the way we get exposure and it’s a good thing.

Since the May 2010 Flash Crash (when the Dow Jones Industrial Average dropped -9% intraday for those who may have forgotten).  It was the biggest one-day point decline, 998.5 points, on an intraday basis in Dow Jones Industrial Average history. Some thought it could have be caused by ETFs: Leveraged ETFs, the Flash Crash, and 1987, for example.

It seems ETFs and especially leveraged or “geared” ETFs are an ongoing debate about their potential impacts on the market price and volume – especially at the end of the trading day.

Dave Nadig and S.M. Brorup at IndexUniverse.com explored it again recently in Geared ETFs Drive The Market. Or Not.  One conclusion:

“In the end, even with $3 billion in levered and inverse financials, the daily rebalance trade is still likely “just” a few hundred million on a big day. That gets spread across hundreds of financial stocks in the large- and small-cap indexes.”

The bottom line is it doesn’t seem the amount of money invested in these leveraged or inverse ETFs is large enough relative to the total amount of money in the market to make a significant impact. However, market prices are driven by the most basic economics: supply and demand. Any trading activity has the potential to move a price, but we haven’t yet seen any empirical evidence to say leveraged ETFs are the cause of the big price swings we see more of since 2008. Instead, you may consider that investors and traders are just more responsive to changing prices – good or bad.

There are some things we just don’t know for sure, until we do. In the mean time, I consider the possibilities, give them some deep thought, factor it in, so I am prepared for whatever happens next. All things are always uncertain: enjoy it.

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