Remember all that commotion about leveraged and inverse exchange-traded funds (ETFs) awhile ago? That was in 2010, when New York Times writer Andrew Ross Sorkin concluded that leveraged ETFs, which have to rebalance at the end of every day, are the probable cause of extreme market volatility during the last minutes of every trading day. Regulatory scrutiny ensued, and the U.S. Securities and Exchange Commission issued a moratorium on approvals for any requests for new inverse or leveraged ETFs.
The question is, Do they really move markets? And do they pose systemic risks?
A new research paper says probably not. Ivan Ivanov from the Board of Governors of the Federal Reserve System, along with Stephen Lenkey from Pennsylvania State University, addresses the critics of leveraged ETFs by pointing out that they ignore the effects of capital flows on ETF rebalancing demand. The authors demonstrate that capital flows can either increase or decrease ETF rebalancing demand because those flows alter the size of the ETF. That affects the amount of additional leverage the ETF requires to maintain its target leverage ratio.
They also find that capital flows reduce the potential for leveraged and inverse ETFs to boost market volatility. Here’s what the authors say.
Using a sample of large U.S. equity-based ETFs, we find that capital flows occur frequently and tend to offset the need for ETFs to rebalance their portfolios. Furthermore, the effect of flows on ETF rebalancing demand is strongest when returns are large in magnitude, which is important because ETFs would presumably be most prone to amplify market movements in these cases.
Digging deeper into the workings of leverged and inverse ETFs, the authors also look at the relationship between returns, capital flows and ETF rebalancing demand over different parts of the distributions of capital flows and rebalancing demand. Here, the correlation between flows and returns suggests that both capital inflows and outflows mitigate the need for ETFs to rebalance.
Ivanov and Lenkey are contributing to a widening body of literature that refutes the link between ETFs and extreme market movements. You can download the whole paper here.