Reports that leveraged ETFs will disrupt market are overblown

This particular brand of ETF is designed to give short-term traders leveraged long or short exposure to a variety of indexes.

The Direxion Daily Large Cap Bull 3X Shares (BGU), for example, seeks to replicate 300% of the daily performance of the Russell 1000 Index. On the short side, the UltraShort QQQ ProShares (QID) offers traders exposure to twice the inverse of the daily performance of the Nasdaq 100 Index.

Although the basic concept has been around as a niche mutual fund strategy since 1994, the ETF version emerged in 2006 and is quickly gaining appeal.

So much appeal, in fact, that some critics are jumping to the conclusion that a strategy that represents less than $35 billion could — under extraordinary market conditions — wind up contributing more than 75% of late-day trading volume.

The general premise is laid out in a 23-page report released last month by Barclays Global Investors of San Francisco, a unit of Barclays PLC in London.

The cause for concern regarding the leveraged ETFs, according to report co-authors Minder Cheng and Ananth Madhavan, focuses on the portfolio re-balancing that takes place at the end of each trading day.

In order to position the funds for the next trading day, the portfolios need to re-balance in the same direction as the market, which means a bull fund will be buying when the market is up and a bear fund will sell when the market declines.

Because this typically happens in the last 30 minutes of trading, and because of the added volume created by the leverage multiples, the theory is that leveraged ETFs could overwhelm the market with trading volume, further exacerbating big market moves up or down.

“Irrespective of whether the fund is long or short, it will be buying if the market goes up and selling if the market goes down,” Mr. Madhavan said. “And that impact on the market grows with increased assets under management and with increased leverage.”

By Mr. Madhavan's calculations — cited often by critics — if the stock market makes a 5% one-day move, leveraged ETFs would represent 50% of the so-called market-on-close trading volume.

In the event of a 15% market move up or down, leveraged ETFs' share of the last trades of the day would swell to 75%. It is scary stuff, until you consider a few other significant variables related to how leveraged ETFs actually re-balance.

For starters, the bulk of the re-balancing by these funds takes place in the last half hour, not through the much narrower window of market-on-close transactions that coincide with the closing bell.

Thus, instead of representing 17% of the $4.5 billion worth of normal closing-bell transactions, leveraged ETFs represent about 5% of the $50 billion worth of trading volume during the last half-hour, according to an analysis by Credit Suisse Securities LLC in New York.

Another problem with the Barclays research is that it doesn't consider how trading in general might increase during an extreme market move, but only calculates additional volume with regard to leveraged ETFs. “We don't actually know the volume of re-balancing activities; it's an estimate,” said Mr. Madhavan, who added that “we're not taking hypothetical to the level of projecting both the numerator and the denominator.”

Meanwhile, just three firms make up the entire leveraged ETF industry. ProShares Advisors LLC in Bethesda, Md., is the largest player with $25 billion under management in the strategy.

Rafferty Asset Management LLC in Garden City, N.Y., has $4 billion under management under the Di-rexion banner. And Rydex Investments of Rockville, Md., manages about $2 billion through the strategy.

Ultimately, the argument that leveraged ETFs could grow to dominate volume and fuel runaway volatility seems to be grounded in incomplete math.

“As I see it, that Barclays report is really a competitive marketing piece dressed up to look like an academic study,” said Michael Sapir, Pro-Shares' chief executive.”

“If you can't attack the data you attack the motive,” Barclays spokeswoman Christine Hudacko said in response to Mr. Sapir's comment.

A new Investment Insights -column appears every Monday on InvestmentNews.com. E-mail Jeff Benjamin at -jbenjamin@investmentnews.com.