WSJ:Will Leveraged ETFs Put Cracks in Market Close?

shawle

Will Leveraged ETFs Put Cracks in Market Close?
By JASON ZWEIG



At 3 p.m., do you get queasy just thinking about the toll that the final hour of trading might take on your portfolio?



New research suggests that on days when the indexes make big moves, leveraged exchange-traded funds could trigger a trading cascade, turning the market close into a buying or selling frenzy.



To be fair, there has been no meltdown -- yet. But as the financial crisis has intensified since last fall, the final hour of the trading day has felt rougher than ever.



Leveraged ETFs offer double or even triple the daily return of a market index. Some of them, called "inverse" ETFs, move opposite to the market -- for example, going up twice as much as an index goes down. Each day, they all adjust their exposure by rebalancing, or "releveraging," their positions.



These funds are the hottest thing on Wall Street. In March alone, $3.4 billion of new money poured into ETFs that use leverage to magnify the returns on U.S. stocks.



Further amplifying the ETFs' actions: Every day, trading desks at big banks and brokerage firms blast out customized spreadsheets to favored clients. These tools, linked to live data feeds, predict whether the leveraged ETFs will be buying or selling as 4 p.m. approaches. That enables hedge funds and other big investors to trade ahead of the ETFs.



The excessive trading set off by releveraging is perfectly legal -- but upsetting to many people. "The market doesn't seem like a fair, level playing field," says Andrew Brooks, head of U.S. equity trading at T. Rowe Price in Baltimore.



Now a respected analyst -- Ananth Madhavan, head of trading research at Barclays PLC's Barclays Global Investors -- has released a report arguing that the potential ripple effects of releveraging have been underestimated.



Leveraged ETFs usually generate a multiple of the market's daily return by using something called a "total-return swap." Imagine a fund with $100 million in net assets and 200% leverage, meaning that it seeks to deliver twice the market's daily return. That requires the fund to maintain $200 million in swap exposure.



In a long swap, a counterparty like a bank or brokerage firm agrees to pay the fund $2 for every $1 rise in the closing value of a market index that day. On the other hand, if the market falls, the fund must pay the counterparty 2-for-1.



Now let's say the fund's net assets grow by $10 million during the day, to $110 million. The fund must raise its swap exposure from $200 million to $220 million to honor its 2-for-1 investment objective. That is $20 million in extra buy orders, all coming into the market after 3:30 p.m., typically in the final 10 minutes.



An inverse fund also must buy on a day when the market is up; since the value of its hedge has gone down, the fund must increase its exposure to keep its leverage ratio constant. Thus, all these ETFs buy in lockstep in the last few minutes of an up day for their index -- and sell in a swarm at the end of a down day.



Mr. Madhavan estimates that if a market index moves 15% in a day, leveraged ETFs could constitute 75% of all volume at the close of trading. Remember, the Dow fell 23% on Oct. 19, 1987. A major move could send volatility through the roof, and prices through the floor, in a day's final minutes.



Narrower markets may already be feeling an impact. William Bernstein of Efficient Frontier Advisors says that between 2002 and 2007, there were only two days on which U.S. real-estate investment trusts went up or down by an average of more than 5%. Since the beginning of 2008 there have been 83 such days. That period includes the collapse of the real-estate market, of course, but also the rise of leveraged real-estate ETFs, which command $1 billion in assets. Trading in the largest of these funds averages about 8% of the total dollar volume in daily REIT turnover.



"I don't want to sound like a Cassandra," Mr. Madhavan says of the ETF releveraging, "but this could create a lot of problems. Could it lead to a systemic risk? We may not have seen the biggest effects yet."



Many people don't share Mr. Madhavan's concerns. (His employer is affiliated with iShares, an ETF outfit that competes against leveraged funds for market share.) Across the U.S. stock market, estimates portfolio strategist Phil Mackintosh of Credit Suisse, leveraged ETFs typically account for "less than 4% of total trading in the last hour."



Andy O'Rourke, head of marketing at Direxion Funds, says his firm has researched the potential impact of daily rebalancing by its leveraged ETFs, "and it hasn't really been significant enough to have a big impact." ProShare Advisors, the largest provider of leveraged ETFs, is studying Mr. Madhavan's report and hasn't had time to fully critique it. But Michael Sapir, ProShares' chairman, says: "Our initial view finds significant holes and unsubstantiated conclusions in the report."



The market's shrewdest players use the releveraging by ETFs to their own advantage. The rest of us are left reaching for the Rolaids. Here's hoping the side effects never get worse than that.

shawle

This helps explain the late day volatility.