- Nomura suspends $6 billion fund after liquidity concerns
- SEC warned U.S. investors about dangers six years ago
Six years ago, securities regulators told U.S. investors they were confused about leveraged exchange-traded funds and should consider avoiding them. The message has yet to catch on in Japan.
That became apparent Wednesday after the crush of money flowing into the Next Funds Nikkei 225 Leveraged Index ETF spurred its overseer to halt additional deposits, according to a statement on its website. Assets under management in the ETF have doubled since May to 734 billion yen ($6.16 billion), making it the biggest security of its kind in the world even as its price has declined almost 26 percent.
To some, Japan’s love affair with a security that has done little but shred money for five months is a predictable byproduct of Prime Minister Shinzo Abe’s push to make the stock market a proving ground for policies to restore the economy. Since he came to office, Japan’s central bank has expanded its purchases of ETFs while the nation’s $1.1 trillion retirement fund raised equity holdings.
“You’ve seen the Japanese government be a cheerleader for the stock market,” said Brendan Ahern, a New York-based managing director for Krane Fund Advisors LLC. “They’ve pushed institutional investors into the market and retail investors are following that lead,” he said. “You have to wonder if they’re aware of the issues involving compounding for leveraged ETFs.”
While Nomura Asset Management Co. cited inadequate liquidity in futures markets, the decision to suspend inflows came after several months of especially unlucky trading in the ETF, which is designed to rise or fall twice as fast as its namesake equity gauge. Investors poured a record $4.5 billion into the ETF over two months starting in August, a period when the Nikkei 225 slumped 11 percent.
Nomura was quick to point out that the fund will continue to accept redemptions and is trading normally on the Tokyo stock exchange. At the same time, halting the free flow of money into the security is the kind of wrinkle ETF critics say individual investors aren’t prepared for.
Leveraged funds are designed to pay owners some multiple of the gauges they track, usually two or three times the daily return, enabling investors to make bigger profits or losses in times of market turbulence. In Japan, the Nikkei ETF has become more popular with traders than Toyota Motor Corp. Average turnover for the ETF was about 250 billion yen ($2.1 billion) a day over the past two months, triple that of Japan’s biggest company.
Concern about the products has existed for years. In 2009, the U.S. Securities and Exchange Commission and Financial Industry Regulatory Authority published an investor alert imploring individual investors to make sure they understood leveraged and inverse ETFs before purchasing one. The bulletin focused on how the compounding effect of leverage could cause the securities to veer wildly, potentially generating losses in up markets.
“While there may be trading and hedging strategies that justify holding these investments longer than a day, buy-and-hold investors with an intermediate or long-term time horizon should carefully consider whether these ETFs are appropriate for their portfolio,” the alert read. “Only invest if you are confident the product can help you meet your investment objectives.”
A year after sending the notice, the SEC announced that it would review the use of derivatives in ETFs and mutual funds, enacting a moratorium that barred new entrants in the U.S. That hasn’t kept them from sprouting up elsewhere.
The Next Funds ETF was started in 2012, while another security, the Fubon SSE180 Leveraged 2X Index ETF, which provides double the return of the Shanghai Stock Exchange, began in Taiwan last November. A product called the YUANTA/P-shares Taiwan Top 50 1X Bear ETF, which provides the inverse return of a Taiwan stock benchmark, also had its inception last year.
In Japan, concern has been growing that the Nikkei ETF was getting so big that the trades needed to keep its price in line -- most of them carried out at the end of the day -- had the potential to sway the entire stock market.
For every 1 percent swing in the Japanese equity market, leveraged and inverse funds have to buy or sell about $285 million near the close, according to a Sept. 12 report by Bank of America Corp.’s Merrill Lynch unit. On Sept. 9, when the benchmark index surged 7.7 percent, about 17 percent of trades in Nikkei 225 futures during the daytime session of Japan’s exchange were executed in the final half hour.
The Next Funds ETF held 79,855 Nikkei 225 futures contracts on Oct. 14, about 23 percent of market-wide open interest, according to data compiled by Japan Exchange Group Inc. and Bloomberg. The ETF has raised its subscription limit at least twice this year, doubling its capacity to 2 trillion yen as recently as this month.
“Liquidity in futures remains the same, but our funds have gotten bigger,” said Kazumasa Hironaka, a spokesman at Nomura Asset. “If the fund can’t buy at the price it wants to and sell at the price it wants to, it’ll skew its ability to track the index.”
It’s not the first time an exchange-traded product has run into obstacles because of its own popularity. Credit Suisse Group AG had to suspend the creation of new stock in the VelocityShares Daily 2x VIX Short-Term ETN in February 2012, after demand for the security hit a limit set when the product was created in 2010. Barclays Plc also halted issuance in its iPath Dow Jones-UBS Natural Gas Total Return Sub-Index ETN in August 2009.
Among those concerned about the dangers of leveraged ETFs is Laurence Fink, chief executive officer of BlackRock Inc., the world’s largest money manager. He said last year that the products are a structural problem and have the potential to “blow up” the industry. In 2011, he compared the development of hard-to-understand ETFs to financial engineering in the mortgage-backed securities market, which played a key role in the 2008 financial crisis.
“Investors tend to have trouble using volatile funds correctly,” said Michael Rawson, an ETF analyst at Morningstar Inc. in Chicago. “They can be used appropriately by people who have the wherewithal and the desire to monitor and trade positions daily. But over a long period of time, these funds are not really suitable to a retail investor.”