The tools traders use to play the market are getting more powerful—and potentially dangerous. Investors have long been able to buy leveraged ETFs, exchange-traded funds that aim to magnify the daily returns of the indexes they follow. On Dec. 1, Direxion Funds upped the ante by converting its “two-times” funds to provide triple the return of the indexes they track. Supersizing has been good business for Newton (Mass.)-based Direxion, which offers more than 40 leveraged ETFs, up from eight three years ago, according to Chief Marketing Officer Andy O’Rourke. Yet some critics say the pumped-up investment vehicles are adding to daily volatility and scaring off general investors from the market.
Laurence D. Fink, chairman of BlackRock (BLK), the world’s largest asset manager, has called leveraged ETFs “toxic.” At an investor conference on Nov. 16, Fink said he was surprised that some were approved by U.S. regulators. He compared them to the financial engineering of complex securities that ultimately led to the collapse of the U.S. mortgage market. “I do believe we have some responsibility for making sure that the market does not morph itself, the same way when I started in the mortgage market 35 years ago, watching a great market morph into a monster,” he said.
ETFs are baskets of securities that track an index and trade throughout the day like stocks. Leveraged ETFs use derivatives such as options and futures to deliver a multiple of the daily return of an index. Another variety, leveraged inverse ETFs, seeks to give some multiple of the opposite return for an investor who wants to bet against the market. ProShares’ UltraShort Financials ETF aims to move twice as much as, and in the opposite direction of, the Dow Jones U.S. Financial Index. If that index falls 2 percent, the fund is designed to rise 4 percent. If the index gains 3 percent, the fund should fall 6 percent.
ETFs account for 35 percent to 40 percent of trading on U.S. stock exchange volume, according to research firm Morningstar (MORN). While leveraged and inverse funds make up just 3 percent of ETF assets, they account for 14 percent of total ETF trading, and investors hold leveraged and inverse ETFs for an average of three days, compared with 16 days for plain-vanilla ETFs, Morningstar says. Sharon Snow, chief executive officer of Metropolitan Capital Strategies, a $100 million ETF-based asset manager in Manassas, Va., credits leveraged and inverse ETFs with helping the firm achieve 10 percent annualized returns over the past five years. “We love them and use them as they are intended, as short-term trading vehicles,” she says. “They help you be tactical and manage risk.”
Critics contend that ETFs exacerbate market swings by lumping into one security assets that are alike but not the same. In the past, buying 50 stocks required 50 decisions, now it’s just one. In September, the Wall Street Journal reported that the Securities and Exchange Commission was looking into whether amplified ETFs contributed to the market’s unusual volatility in August. The SEC declined to comment for this story. In an October Senate Banking subcommittee hearing, Senator Jack Reed (D-R.I.) said critics have referred to leveraged ETFs as “new weapons of mass destruction that are turning the market into ‘a casino on steroids.’ ” Others, he said, “believe they are a more efficient, modern, and tax-advantaged method of investing.”
Eileen Rominger, director of the SEC’s Investment Management Div., told the panel that since March 2010 the staff has deferred approval of new ETFs that make heavy use of derivatives while it examined their effect on market volatility and other issues. (Companies that had approvals already are able to bring out new ETFs.) In August 2009 the Financial Industry Regulatory Authority and the SEC issued a warning to retail investors about the risks associated with leveraged ETFs—including the possibility of large losses and poor tracking of the underlying index over longer periods because the funds are designed to generate their targeted return over a single trading day.
Harold S. Bradley, manager of the Ewing Marion Kauffman Foundation’s $1.7 billion endowment, counts himself among the critics. In an interview, he says leveraged ETFs cause a daily “romp-to-the-close” phenomenon, where they scramble to buy and sell shares during the last hour of trading, amplifying market gains and losses. “Leveraged ETFs aren’t tracking stocks as much as they are creating stock prices,” he says. “That undermines investor confidence.”
Michael Bodino, head of energy research at Global Hunter Securities, says his studies support the idea that money flowing into leveraged energy-sector ETFs acts as a kind of “self-fulfilling prophecy,” influencing stock prices in the sector more than changes in the price of oil and natural gas do.
Direxion marketing chief O’Rourke dismisses such contentions. “I guess people are looking for a scapegoat,” he says. “Every study that we’ve seen done concludes that the asset and volume levels of leveraged ETFs are nowhere near significant enough to have much of an impact on the market.” O’Rourke and Michael L. Sapir, CEO of ProShare Advisors, both point to separate studies by William J. Trainor, a finance professor at East Tennessee State University, and investment bank Credit Suisse Group (CS) that say leveraged ETFs have a negligible role in the market. With $30 billion to $50 billion in assets, the studies say, leveraged ETFs do not have the power to distort the $15 trillion U.S. stock markets. “We have seen no credible analysis that concludes geared ETFs have a material, harmful effect on the markets,” says Sapir.
Michael Rawson, who covers ETFs for Morningstar, doubts that leveraged ETFs are roiling the market. Even so, he thinks more research on the question is needed. “The effect of leveraged ETFs is very hard to quantify,” he says. “There just isn’t solid proof yet.”