Leveraged/Inverse ETFs: Not Wagging The Dog

October 17, 2011

It seems not a week goes by when someone isn't raising the scare-tactic flag over ETF-istan. Why don't people look at the actual data?


Last week saw another round of ETF histrionics. The latest salvo was an old saw—that leveraged and inverse funds were to blame for the increased volatility in the U.S. markets.

Media bigwigs hit the theme not once, but twice: First, Andrew Ross Sorkin of the New York Times posted a piece titled "Volatility, Thy Name Is E.T.F."; then, Herb Greenberg of CNBC added his own thoughts in "Proof: ETFs a Self-Fulfilling Prophecy."

It's easy to understand the concern. Average investors—which we presume means everyone but those most evil of cartoon villains, hedge fund managers—hate volatility, and for good reason. Volatility means uncertainty and, paraphrasing Yoda: Uncertainty leads to anxiety; anxiety leads to bad decisions; and bad decisions lead to suffering.

I'm no apologist for leveraged and inverse funds. I think they're inappropriate for the vast majority of investors.

I know firsthand that there are financial advisors and investors who have money in those type of funds and still don't understand how they work. But there's a big difference between being a niche, complex and sometimes misused product and being a threat to modern capitalism. Yet that's precisely what they're often made out to be.

Too often, those accusations are made on hunches and correlation, with no causal link or hard-data support. We figured it would pay to actually look at the data independently and put that data out in the open.

Leveraged And Inverse Funds Both Trade With The Market

The first thing to understand is that all leveraged and inverse funds—regardless of whether they are betting for or against the market—are "pro-cyclical." That is to say, the daily rebalancing the funds are required to do to maintain exposure each day is always in the direction of the market.

This is counterintuitive and often misreported. Most people assume that leveraged and inverse funds balance each other out. In fact, both types of funds must buy extra exposure on days that the markets go up, and sell exposure when markets go down.

Here's a quick look at how it works in principle. Imagine you're dealing with a single share of a $100 fund, at one of five different leverage factors, and comparing an up and a down day in the markets.

Leverage Factor Starting NAV Starting Exposure
Leverage/Inverse Return Closing NAV End of Day Exposure Needed Exposure Net Market on Close Trade
Net Market Exposure Of Leveraged Or Inverse Funds based On +10% Daily Return
S&P Return 10%
-3 $100.00 -$300.00 -30.00% $70.00 -$330.00 -$210.00 $120.00
-2 $100.00 -$200.00 -20.00% $80.00 -$220.00 -$160.00 $60.00
-1 $100.00 -$100.00 -10.00% $90.00 -$110.00 -$90.00 $20.00
2 $100.00 $200.00 20.00% $120.00 $220.00 $240.00 $20.00
3 $100.00 $300.00 30.00% $130.00 $330.00 $390.00 $60.00

Leverage Factor Starting NAV Starting Exposure
Leverage/Inverse Return Closing NAV End of Day Exposure Needed Exposure Net Market on Close Trade
Net Market Exposure Of Leveraged Or Inverse Funds based On -10% Daily Return
S&P Return 10%
-3 $100.00 -$300.00 30.00% $130.00 -$270.00 -$390.00 -$120.00
-2 $100.00 -$200.00 20.00% $120.00 -$180.00 -$240.00 -$60.00
-1 $100.00 -$100.00 10.00% $110.00 -$90.00 -$110.00 -$20.00
2 $100.00 $200.00 -20.00% $80.00 $180.00 $160.00 -$20.00
3 $100.00 $300.00 -30.00% $70.00 $270.00 $210.00 -$60.00


The key thing to note here, again, is that it doesn't actually matter whether a fund is long the market or short the market; the end-of-day trades are always in the direction of the day's trading.

A fund that's levered on a day its index is up needs to get an even bigger chunk of exposure tomorrow, effectively reinvesting its profits. A fund that was short will find itself with too deep a hedge, and will need to unwind its negative exposure—thus also putting buying pressure into the close.

It's important to note that the funds themselves aren't buying or selling anything. All of the levered and inverse funds in the U.S. get their exposure through total return swaps.

Their rebalancing trade is simply resetting the level of the swaps with counterparties—big banks—who, in turn, need to hedge their own risk.

Whether they do that by buying and selling stocks at the close, or simply using the futures markets, eventually, someone in this chain of counterparties will be either making a naked bet on the market (unlikely) or hedging out their risk by putting trades into the actual securities in the market.



Sept 22, 2011: Portrait Of A Bad Day

Let's move beyond the theoretical and into the realm of the specific. The most recent big-swing day in the S&P 500 was Sept. 22, when the index lost 3.19 percent. Here's how the actual leveraged and inverse ETFs tracking the S&P 500 fared on that day:

Ticker Name Leverage Factor Starting AUM on 9/22 Starting Exposure on 9/22 Exposure on Close Exposure Needed on Close Net Market on Close Trade
Assets Under Management Figures in $MM
SPXU ProShares UltraPro Short S&P 500 -3 $507.00 -$1,520.99 -$1,472.49 -$1,666.47 -$193.98
SDS ProShares UltraShort S&P 500 -2 $2,822.84 -$5,645.68 -$5,465.68 -$6,005.69 -$540.01
RSW Rydex Inverse 2x S&P 500 -2 $68.68 -$137.35 -$132.98 -$146.11 -$13.14
SH ProShares Short S&P 500 -1 $2,604.19 -$2,604.19 -$2,521.16 -$2,687.22 -$166.06
SSO ProShares Ultra S&P 500 2 $1,480.10 $2,960.21 $2,865.83 $2,771.45 -$94.38
RSU Rydex 2x S&P 500 2 $69.29 $138.58 $134.16 $129.74 -$4.42
UPRO ProShares UltraPro S&P 500 3 $285.38 $856.14 $828.85 $774.25 -$54.59
Net Rebalance of Inverse/Leveraged Funds: -$1,066.57


Just like in the imaginary example, these seven funds were variously betting both for and against the S&P 500, and they all had to sell or short going into the close on a day the market was already down.

This looks bad for levered and inverse funds. It's entirely rational to walk through the above logic and conclude that the presence of these funds in the market should make a bad day worse. But before we jump to conclusions, let's place that $1 billion trade in context.

What was the aggregate traded value of the S&P 500 going into the close? We calculated this by looking at the value traded in 10-minute blocks, from the open through the close, including the market-on-close auction, which is generally reported after the close.


S&P 500 Stocks: Value Traded 9/22/11


Full Day's Trading: 174,947,423,779
Final 10 minutes+MOC 19,504,155,239
Final 30 minutes+MOC 35,566,878,772


In the final 10 minutes of trading, almost $20 billion of underlying S&P 500 stock changed hands. Of that, we can assume that $1 billion was the result of the leveraged and inverse funds, or about 5 percent.

More realistically, the portfolio managers at the leveraged and inverse fund shops probably started working their swap positions well before the close, and thus their counterparties were in the market establishing or liquidating positions in anticipation of the final exposure requirements.



What Is Market-On-Close?

It's worth understanding what this "market-on-close" thing is, anyway. Throughout the day, the exchanges accumulate order flow marked for "market-on-close," or MOC, pricing. As the name suggests, a market-on-close order means that your order will be filled at the closing price.

That closing price is actually a somewhat complex calculation based on an automated order-imbalance auction run by the New York Stock Exchange (or other exchanges). In principle though, it's the price where the maximum number of market-on-close and limit-on-close shares can trade hands, and is generally very close to the last traded price at 3:59 p.m. Eastern time.

The primary users of market-on-close orders are institutions and index fund managers, who are mainly concerned with tracking error. By definition, putting your trades in the MOC auction means you'll get extremely good tracking to an index like the S&P 500, which itself is calculated on those same closing prices.

But you'll notice that the volume in the final 10 minutes far exceeds the volume actually marked at and after the close, and this is fairly typical. Investment managers often trade the close rather than relying on the auction.

Regardless, the worst-case scenario is that these seven leveraged or inverse funds represented only 5-6 percent of value traded in the final 10 minutes of that hugely volatile day.

A valid criticism of this analysis would be that it undercounts the impact of leveraged and inverse funds as a whole, as it focuses only on S&P 500 funds.

To address that critique, we ran the same study against all levered and inverse ETFs investing in U.S. equities with static leverage factors.

When all those 102 funds are considered, the net end-of-day trading required to rebalance based on the performance of the funds themselves would have been roughly $3.8 billion. While this sounds like a large number, consider the comparable value-traded data for the Russell 3000 securities, representing effectively the entire U.S. equity market:


Russell 3000 Stocks: Value Traded 9/22/11


Full Day's Trading: 218,919,513,824
Final 10 minutes+MOC 25,118,084,644
Final 30 minutes+MOC 45,348,146,711


That $3.8 billion to sell represents just 15 percent of the final 10-minute volume, and well under 10 percent of the final 30 minutes of trading.

The Momentum Argument

While we could argue about whether 5 percent or 10 percent or 15 percent of closing volume is enough to matter, the market can settle the argument for us. If the pro-cyclical pressure of these funds was causing the market to move further than it might otherwise, this should be evident in the data. However, it's not.

Looking back to the beginning of this recent downturn—April 1, to pick a fairly stable date—we looked at the momentum of the market from 3:00, 3:15, 3:30 and 3:45 to close. Because of the pro-cyclical nature of the leveraged/inverse daily rebalance, if that activity were to have a serious effect, we'd expect to see an acceleration of the day's trend. That is, on a day with the S&P down 1 percent at 3 p.m., we'd expect it to be down more than 1 percent by the end of the day.

We chose four "start times" for this study, as in our conversations with issuers, it's clear they all begin their swap coverage negotiations at different times following 3:00 pm.

Here are the results for the S&P 500:

3:00-Close 3:15-Close 3:30-Close 3:45-Close
Reversed Trend 67 68 58 67
Accelerated Trend 69 68 78 69


Far from a trend, the data suggests it's truly a coin flip at any time in the last hour of trading about whether the market accelerates or reverses course. It's even more obvious when looking at the momentum of the Russell 3000:

3:00-Close 3:15-Close 3:30-Close 3:45-Close
Reversed Trend 75 64 64 119
Accelerated Trend 61 72 72 17


Not only is there no clear trend in the first three time periods, the data for the last 15 minutes of trading would suggest that on the vast majority of days, the market actually reverses heading right into and through the closing auction. In other words, the leverage/inverse effect was not just neutralized but reversed by other factors.

Another version of this analysis would look at the change in price from close to the next morning's open, testing the idea perhaps that closing prices were not reflective of market sentiment, and thus would revert the next morning.

Excellent work on just this phenomenon was done by William Trainor of East Tennessee State University last year, so I have not duplicated his efforts. He found no predictive value in previous days' closing price movements.



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.


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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