Fed pours cold water on leveraged ETF fears

Fed pours cold water on ETF fearsLeveraged and inverse exchange traded funds (ETFs) are not as dangerous as critics have suggested, according to a new Federal Reserve paper that plays down concerns these products create undue market volatility.

Referred to variously as “weapons of mass destruction” and accused of turning the market into “a casino on steroids”, these products have come in for strong criticism by regulators in recent years.

The US Securities and Exchange Commission warned in 2010 about derivatives in mutual funds and the excessive risks from leveraged ETFs. The SEC at one stage even issued a moratorium on approving exemptive requests for new leveraged and inverse ETFs. The Fed itself issued its own warning about these products in 2012.

But in their new paper, ‘Are concerns about Leveraged ETFs Overblown?’, academics Ivan Ivanov and Stephen Lenkey claim concerns are overstated. They say the concerns raised ignore the offsetting effects from capital flows as funds adjust to the benchmarks they track.

They note that “capital flows considerably reduce ETF rebalancing demand and, therefore, mitigate the potential for ETFs to amplify volatility”.

Concerns are based on the perception that leveraged and inverse ETFs “must rebalance their portfolios in the same direction as the contemporaneous return on their underlying assets in order to maintain a constant leverage ratio”, the authors say. However, this reasoning is “incomplete” as it overlooks capital flows.

Empirical evidence shows capital flows “diminish the potential for leveraged and inverse ETFs to exacerbate volatility”.

“Using a sample of large US equity-based ETFs, we find that capital flows occur frequently and tend to offset the need for ETFs to rebalance their portfolios,” say Ivanov and Lenkey.

“Furthermore, the effect of flows on ETF rebalancing demand is strongest when returns are large in magnitude, which is important because ETFs would presumably be most prone to amplify market movements in these cases.”