In Defence of Short and Leveraged ETFs
Wednesday 28th August '13
- Boost response in defence of Short and Leveraged ETFs following the paper published by the Fed’s Mr Tuzun.
- Short and Leveraged ETFs are market access tools and do not drive the market
- Circa $50bn of global assets under management in Short and Leveraged ETFs is inconsequential compared to $2 trillion in ETFs which is less than around 10% of global mutual fund assets
- Investors who use Short and Leverage ETFs often use them to hedge their portfolios, therefore helping prevent short term sell offs
- Other research finds no evidence to back Mr Tuzun’s conclusions
- Short and Leveraged ETFs have significant benefits compared to other forms of leveraged trading
Boost ETP, the award winning and independent exchange traded product (“ETP”) provider, which specialises in Short and Leveraged (“S&L”) ETPs, feels compelled to enter the debate started by Tugkan Tuzun’s Fed paper published in July 2013 (http://www.federalreserve.gov/pubs/feds/2013/201348/201348pap.pdf). Boost feels that there is need for more clarity and reasoned debate around the conclusions of Mr. Tuzun’s analysis.
It appears to us that Mr Tuzun’s main conclusion is that the daily rebalance of S&L ETF which naturally occurs in the same direction in which the market is moving which could trigger a ‘cascade’ reaction leading to a domino effect potentially causing market crashes. Mr. Tuzun provocatively titles his paper “Are Leveraged and Inverse ETFs the New Portfolio Insurers?”. The comparison with ‘Portfolio Insurers’ is clearly designed to grab attention rather than add anything to the analysis.
Boost feels that the view taken and the conclusions reached by Mr. Tuzun are simplistic in approach and ignores the basics of how markets work and the facts related to S&L 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.
Secondly the global assets under management (AUM) of S&L ETFs is around $50bn. This is inconsequential compared to the $2 trillion of AUM in global ETFs, which is actually less than 10% of global AUM in mutual funds. This is further diluted by the fact that S&L ETFs tend to only give access to the most liquid underlying markets, such as the FTSE 100, Gold etc. and not across the broad range of illiquid exposures provided under the broader ETF and mutual funds markets. Some of these exposures can be less liquid than those tracked by S&L ETFs.
Thirdly Mr Tuzun seems to claim that the end of day trading is a major contributory factor. Stock markets tend to see the majority of trading activity at the start and end of the day in a U curve shape. 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.
Finally, Mr Tuzun fails to consider why some investors use S&L ETFs. Boost’s clients very often use S&L ETPs in order to hedge their existing positions. Therefore the likelihood is that if S&L ETFs were not available these investors may be forced to employ more capital in essentially the same way as S&L ETFs do, use other hedging tools which need to be similarly rebalanced, or liquidate positions short term in sharp market movements even though they would prefer to hold them for the longer term, which could in itself could contribute to a “cascade effect”.
Other researchers also disagree with Mr Tuzun’s conclusions. William J. Trainor (2010) concludes that leveraged ETFs do not appear to have any substantial effect on the market. Credit Suisse published a paper in 2011 titled ‘Leveraged ETF Rebalancing in Perspective’ which concluded that “leveraged ETF rebalancing trades are unlikely to be the most influential factor in driving intraday swings into the close”. There has been no significant changes to the AUM or structure of S&L ETFs which would have changed these earlier conclusions .
Hector McNeil, Co-CEO of Boost commented: “We think the Tuzun paper is a head-line grabber and doesn’t stand up to real world scrutiny. Given the size of the S&L ETF market globally and the strategies that investors employ when using them, we firmly believe the impact is minimal. S&L ETFs provide an important tool for investors to hedge their portfolios and protect their investment as well as an efficient way to gain exposure to a market and preserve valuable capital.
“When compared to other ways of gaining leverage or short exposure such as futures, options, CFDs, spread bets and structured products, S&L ETFs have some real benefits. Investors can’t lose more than their initial investment; they don’t need to complete complex derivative documentation; they trade on Exchange with multiple market makers; and counterparty risk is managed through a robust and transparent collateral processes.”
William J. Trinaor, “Do Leveraged ETFS Increase Volatility”, Technology and Investment, 2010, 1, 215-220 Published Online August 2010 (http://www.SciRP.org/journal/ti)
Global AUM in S&L ETFs was approximately $45bn at the end of 2010 and $51bn at the end of Q2 2013.