Leveraged/Inverse ETFs: Not Wagging The Dog

October 17, 2011

 

Following The Flows

One last area of concern in the media has been that the flows into leveraged and inverse funds themselves were to blame for market volatility. The argument typically goes that since fund flows into either leveraged or inverse funds are magnified, you would expect increases in assets to directly drive market volatility as those new positions were established.

Putting aside the fact that with just $21 billion in assets and net exposure of just -$5 billion, it's truly inconceivable that the $5 billion short is wagging the $14.5 trillion Russell 3000 dog, let's nonetheless look at the actual assets in relation to market volatility.

 

Volatility Vs. L&I Assets in US Equities

 

Perhaps the most interesting thing here is how the assets in these products lag actual market volatility.

The spike in assets in mid-2009 came during an environment of rapidly declining volatility in the S&P 500. Similarly, the rise in assets in the summer of 2010 came as volatility was on the wane. In the most recent volatility spike, assets in leveraged and inverse funds only increased after the VIX had spiked and stabilized over 35.

Conclusion

Leveraged and inverse funds aren't for everyone. In fact, they're not for most people. They're expensive, complex and require constant monitoring if held for more than a day.

In this regard, they join a whole host of financial products that need to be used with extreme caution: Options, futures, high-interest no-fee credit cards, adjustable rate mortgages, variable life insurance and car leases come to mind.

Overall, it's my opinion that the leveraged and inverse fund issuers have done a credible job making investors aware of these risks.

But these funds aren't the progenitors of some sort of global collapse.

Their net exposure, assets under management and rebalance-driven trading are simply insignificant in the scheme of the U.S. equity markets.

While their structure has the theoretical potential to drive momentum, the modern markets are so overwhelmed by the intraday trading of institutional index managers, hedge funds and high-frequency traders that the data shows no such impact, and indeed, even with a tenfold growth in assets, the data aren't likely to show a different result.

I'm afraid this angry village will need a different mansion on the hill to storm with pitchforks.

 

 

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