New evidence points to a correlation between geared ETF assets and end-of-day price movements in certain markets. Is the connection real?

In 2011, we published a report in support of hearings taking place in Congress about ETFs. One of the major allegations by the anti-ETF crowd (among a litany of ridiculous claims) was that ETFs had become a very small tail wagging a very large dog. Given that ETF assets tracking the S&P 500 are just 1 percent of the market cap of the actual stocks in the S&P 500, we decided to run the math.

The damning piece of math is somewhat counterintuitive. Leveraged and inverse funds that reset their exposure daily (the vast majority of them) are always buyers on up days, and sellers on down days, regardless of whether they are inverse.

**Pro-Cyclical What?**

That’s a head-scratcher, so here’s how that math works. Imagine you’re in a fund that promises 2x the return of the S&P 500. You put $100 in the fund, which means your notional exposure is $200. The fund company gets that 2x exposure through a negotiated swap with a big money center bank. Now let’s imagine the S&P is up 10 percent today. At the end of the day, that swap is worth $220—10 percent of $200. Your $100 investment is credited with all of the gain, so it climbs to $120 in value.

But here’s the problem. You now have $120 invested in the fund. Your notional exposure tomorrow morning on the open needs to be twice that—$240. But your actual exposure, if the fund company does nothing, is only $220—your $20 profit plus the original $200 swap. To have the full $240 in desired exposure, the fund company goes and gets an additional $20 in exposure right before the close. It’s a buyer on an up day.

The head-scratching part is that the same trading happens for the -2x inverse version of the same fund. Let’s start with the same $100 investment, which buys a swap offering -$200 in exposure. The S&P goes up 10 percent. You lose. The value of that -$200 swap is now just $180, and you get debited that loss, so your $100 investment is only worth $80 now.

Now there’s a different problem. You have $80 invested in the fund, so the notional exposure you need tomorrow morning is just -$160. But the fund ended the day with -$180 in swaps. It has to get rid of that -$20 difference. Put another way, it’s ALSO a buyer on an up day.

Nerds like us call that “pro-cyclical”—leveraged and inverse funds are always buying into the market on up days and selling on down days. That pro-cyclicality means that, if the money in leveraged and inverse funds was big enough, you’d expect them to accelerate the day’s trends, every single day.