World's Biggest Leveraged ETF Halts Orders on Liquidity Concern

Updated on
  • Fund manager Nomura says size may curb ability to track index
  • Some investors say ETF flows are increasing market volatility

The world’s largest leveraged exchange-traded fund is getting too big for the market it was designed to track.

Nomura Asset Management Co. will halt subscription orders for its Next Funds Nikkei 225 Leveraged Index ETF and two other funds from Friday, it said in a statement on its website. The money manager, which relies on the futures market to deliver two times the daily return of Japan’s most famous stock index, said liquidity isn’t deep enough to ensure it can meet that target.

Surging inflows from individual investors have made the Nikkei 225 ETF one of the biggest players in Japan’s futures market, sparking concern among some analysts that the fund’s trades are exacerbating price swings. Assets under management have doubled in just five months to 734 billion yen ($6.16 billion), even as the benchmark index fell 13 percent from this year’s peak in June.

“It seems that the ETF has become too big and is moving the market, and that they’re unable to secure the liquidity they need,” said Michiro Naito, an equity derivatives and quantitative strategist at JPMorgan Securities Japan Co. 

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. Because ETFs tend to place orders near the end of the trading session to mimic closing levels in their underlying indexes, some analysts have blamed them for increasing late-day market moves.

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.”

Stocks Gain

The fund will continue to accept redemptions and is trading normally on the Tokyo stock exchange, Nomura Asset said. The Next Funds ETF, which climbed 2 percent today on volumes in line with the three-month average, closed at a 0.3 percent discount to its underlying net assets on Wednesday. ETF managers use subscriptions and redemptions to keep prices aligned with supply and demand.

Nomura Asset’s decision to halt subscriptions contributed to gains in Japanese shares on Thursday as it highlighted strong investor demand for stocks, according to Andrew Clarke, director of trading at Mirabaud Asia Ltd., a Hong Kong brokerage.

“Too much money has been directed and is still being directed to these ETFs and others,” Clarke said. “If they don’t accept it, it will just go directly into the market.”

BlackRock Concerns

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.

Assets in all yen-denominated ETFs have more than doubled over two years to 14.5 trillion yen in September, data compiled by Bloomberg show. That compares with 35 percent growth in global ETF assets in the two years through August, according to BlackRock, which oversees about $4.5 trillion worldwide.

Most investors in the Next Funds ETF are individuals who tend trade in the opposite direction of the index, suppressing volatility, Tomohisa Hanabata, a senior manager at Nomura Asset, said in an interview on Oct. 9. Traders have poured about $4.38 billion into the leveraged ETF since Aug. 12, a period when the Nikkei 225 tumbled 11 percent amid a global equity rout.

Contrarian Trades

Investor inflows in falling markets, and vice versa, have been a feature of Japan’s equity market for years. In 2013, when the Nikkei 225 soared 57 percent for its biggest gain since 1972, Japanese individual investors sold 8.75 trillion yen of the country’s shares. They bought in the week through Oct. 10, 2008, as stocks plunged 24 percent.

“Looking at past orders, we tend to see contrarian investing,” Hanabata said.

Leveraged ETFs are probably fueling market swings because they need to buy when the market is up and sell when it falls, according to BofA analysts led by William Chan. That means there’s increased odds of “outsized” moves during periods of market stress, they wrote last month. A measure of volatility for the Nikkei 225 jumped to its highest level in 4 1/2 years in August and is still above its five-year average.

New subscriptions for the Next Funds Nikkei 225 Double Inverse Index ETF and the Next Funds Nikkei 225 Inverse Index ETF will also be halted, Nomura Asset said. The firm will consider lifting the suspensions on new orders if redemptions reduce assets under management or liquidity in the futures market improves, according to Hironaka. Japan Exchange declined to comment.

— With assistance by Yuji Nakamura

(Updates with quote in fourth paragraph.)
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