The ETF Whale Blamed for Moving Japanese Markets Gets Reeled In

  • Leveraged ETF seen by some traders as fueling late-day moves
  • CLSA sees potential market impact receding after order halt

In the final moments before Japan’s stock exchange closes each day, one investor has increasingly captured the attention of traders in Tokyo: the world’s biggest leveraged exchange-traded fund.

Run by Nomura Asset Management Co., the Next Funds Nikkei 225 Leveraged Index ETF has more than doubled its assets over the past five months to the equivalent of $6.5 billion. Because it needs to buy near the end of the trading day when shares rise (or sell if they fall), the fund has been accused by some traders of amplifying moves in Asia’s second-largest equity market. More than 70 percent of the time over the past two months, the Nikkei 225 Stock Average has compounded its intraday return in the final 15 minutes.

While Nomura Asset has denied that it’s causing the late-day moves, the money manager took the rare step of halting new subscription orders for the Next Funds ETF last week. Over time, cash will probably flow out of the fund, diminishing the market impact of both the ETF and the speculators who try to front-run its trades, according to CLSA Ltd. strategist Nicholas Smith. Anything that dampens volatility will be good news for long-term investors put off by the biggest Japanese share-price swings in two years, Smith said.

“Leveraged ETFs are important to have around to increase people’s investment alternatives, but when it becomes the majority of the story, that’s a problem,” he said in a phone interview from Tokyo on Friday. “Long-only investors certainly don’t want the extra volatility.”

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. Some speculators try to anticipate this demand, driving up activity in both shares and the futures market, which is used by leveraged funds to produce multiples of the return on their underlying indexes, according to Seiichi Suzuki, a market analyst at Tokai Tokyo Securities Co.

Inadequate Liquidity

Nomura Asset cited inadequate liquidity in Japanese index futures for its decision to halt subscription orders for its leveraged ETF. The fund 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.

Despite its growing heft in the futures market, Nomura Asset rejected the assertion that its trades are increasing volatility. Investors in the ETF tend to be contrarians, selling when the market rises and vice versa, Tomohisa Hanabata, a senior manager at the firm, said in an Oct. 9 interview. Those capital flows reduce the size of trades the ETF must make to ensure it delivers its promised returns, he said.

Excess Volatility

That view is backed up by a U.S. Federal Reserve analysis of leveraged ETFs in America’s equity market. The Fed paper, published last November by economists Ivan Ivanov and Stephen Lenkey, concluded that concerns over the funds’ market impact are probably overblown.

In Japan, the firepower of leveraged funds has grown so big that their trades are amplifying end-of-day moves, BofA analysts William Chan and Puay-Ing Ong wrote in a Sept. 12 report. They pointed to data showing the correlation between returns in the Nikkei 225 during the final 15 minutes and the rest of the trading day has increased to about 0.6, from around minus 0.4 at the end of last year.

“ETFs are clearly becoming a larger part of daily turnover,” said Michael Newman, head of corporate advisory at Custom Products Research Ltd. As the leveraged funds get bigger, “the pressure on excess volatility also is rising,” he said.

The Nikkei 225 slipped 0.9 percent in Tokyo on Monday, as the Next Funds ETF lost 1.4 percent.

While Nomura Asset has halted subscriptions for the ETF, it will keep accepting redemptions. If investors begin to pull money out, that should reduce the fund’s market impact, said Tomoichiro Kubota, a senior analyst at Matsui Securities Co. Shareholders have already withdrawn the equivalent of $666 million in the eight trading sessions through Oct. 15, after pouring in $5.8 billion during the preceding five months, data compiled by Bloomberg show.

“In theory, volatility should shrink,” Kubota said.

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