Bigger Stock Swings Lead to Surge in Leveraged ETF Rebalancing

  • Traders invest in the ETFs to magnify profits amid volatility
  • Credit Suisse says rebalancing doesn't exacerbate stock swings

As stock-market volatility jumped in recent weeks, so did money spent on the arcane process of rebalancing leveraged exchange-traded funds.

Levered ETFs such as the ProShares UltraPro QQQ and the Direxion Daily Financial Bull 3X Shares grew more popular last quarter, with investors pouring the most money into them since at least 2011. That sparked a doubling of rebalancing activity -- the process by which market makers ensure the funds deliver their promised returns -- although it was still lower than four years ago, according to Credit Suisse Group AG.

Leveraged funds are designed to pay owners some multiple of the indexes they track, usually two or three times the daily return, enabling investors to make bigger profits -- or losses -- in times of market turbulence. The ETFs are aimed at short-term traders and have occasionally come in for criticism for diverging from underlying gauges or exacerbating stock correlation and volatility.

The risks are “largely exaggerated, but you have to be careful as well,” said Irene Bauer, chief investment officer at Twenty20 Investments, a London-based firm that specializes in ETF portfolio solutions. “When it’s a volatile environment, it can help to be 2X or 3X, but you need to have conviction, especially given how quickly markets can change directions.”

The reason for rebalancing has to do with the way changes in the value of an underlying index affect the leverage ratios of the ETFs. To simplify: if you own $200 worth of a $100 index, and the index rises to $105, you need to buy a little more to maintain the 2-to-1 alignment. In practice, the process is carried out toward the end of each day through machinations in futures and derivatives markets that some critics say create artificial pressure on underlying stocks.

The process of aligning leveraged ETFs and underlying indexes has resulted in average daily expenditures of $1.4 billion since Aug. 20, Credit Suisse strategist Victor Lin wrote in an Oct. 5 note. That compares with a mean of $634 million this year before then, when volatility was more subdued. Still, this recent increase is smaller than between 2009 and 2011, signaling increased liquidity at the end of day has mitigated the effects of the process, he wrote.

“The liquidity available at the end of the day has continued to grow as more trading shifts toward the close, making the relative size of rebalancing smaller,” Lin said.

Credit Suisse said in 2011 that leveraged ETF rebalancing wasn’t the primary driver of volatility at the close of trading -- a view echoed by economists Ivan Ivanov and Stephen Lenkey in a Federal Reserve paper published last November. Should assets in leveraged ETFs increase, there could be a bigger impact on trading, according to Credit Suisse’s report this week. Surging volatility and a decline in end-of-day liquidity would also have bigger effects, Lin said.

Since Aug. 20, leveraged ETF rebalancing for large-cap stocks has averaged more than 2 percent of the total trading in the last 30 minutes of the day, compared with the 3 percent mean in 2011, Credit Suisse data show.

The drop-off is even more noticeable in small-cap and financial leveraged ETFs. For the former, the average rebalancing activity has shrunk to more than 3 percent of total trading since late August, from about 20 percent four years ago, according to Credit Suisse. It’s slipped to 2.5 percent for financial ETFs, from one-month average peaks of more than 10 percent between 2008 and 2011.

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