This post is the second of three that will look at the potential risks that ETFs may pose to the stability of financial markets. Last week I discussed synthetic ETFs, which use derivatives called swaps to get exposure to their underlying indexes. Now we’ll examine leveraged ETFs.

Leveraged ETFs are designed to provide double or triple the daily return of their underlying index. The Horizons BetaPro S&P/TSX 60 Bull+ ETF (HXU), for example, promises twice the daily return of the popular large-cap Canadian equity index. If the index goes up 2% during the day, HBP will return 4%, and if the index loses 2%, the ETF’s return will be –4%. In the US, some providers even offer triple-leveraged ETFs, such as the Direxion Daily Large Cap Bull 3x Shares (BGU), which delivers three times the daily return of the Russell 1000 index.

A related family of products, called inverse ETFs, move in an opposite direction to the market. If Canadian large caps lose 2% in one day, the Horizons BetaPro S&P/TSX 60 Inverse ETF (HIX) will gain 2%, and vice versa. Many inverse ETFs also use leverage: they may rise 4% when the their index declines 2%, for example.

The problem

Since leveraged and inverse ETFs appeared in 2006, critics (myself included) have argued that these products are potentially harmful for individual investors who may not understand their risks. For an even-handed discussion of these risks, see Dan Hallett’s comprehensive report.

But the recent concerns about leveraged ETFs do not centre around poorly informed individuals. Rather, the US Securities and Exchange Commission is investigating whether these products have played a role in creating extreme market volatility, especially the huge swings we saw in early August.

Although these concerns have been around for a while, they got a boost from an influential October 10 article by New York Times writer Andrew Ross Sorkin. The piece included an interview with hedge fund manager Douglas Kass, who argued that “at the end of every day, leveraged ETFs have to rebalance themselves by buying and selling millions of shares within minutes to remain properly weighted.” This flurry of trading, the article suggests, causes huge swings in the market during the final minutes of each trading day.

What Canadians need to know

Leveraged and inverse ETFs are primarily speculative products that have no place in a long-term investor’s portfolio. But there is simply no compelling evidence that these products pose a systemic risk—that is, that they cause market instability that affects all investors. Sorkin’s article offers nothing but vague suspicions: “Ask any hedge fund manager what their gut says,” is all we get. Let’s consider the other side of the argument:

They’re a tiny blip in the markets. Leveraged ETFs account for a mere 3% of total ETF assets in the US, while inverse ETFs make up another 2%, a market share that a Morningstar analyst called “a grain of sand on the beach.” It is hard to imagine that their rebalancing trades could be a primary cause of daily price movements. “Rather than focusing on leveraged ETFs’ supposed role in boosting market volatility, a more relevant examination would include options, futures and other financial products that increase leverage in the system, the analyst added,” says ETF Trends. “The size and scope of these markets dwarf leveraged ETFs.”

The tail doesn’t wag the dog. At the US Senate subcommittee hearing on October 19, Eric Noll of the NASDAQ presented an analysis showing that “trading in ETFs varies roughly in proportion with overall trading in the market. When news breaks and market prices move, trading volume increases in both the ETFs and the underlying stocks.” In other words, ETFs are responding to market volatility, not causing it. A Credit Suisse report echoed this argument: “We believe it’s a case of confusing correlation with causation.”

The world economy has a few other issues. Those who blame a tiny segment of the securities market for the recent market volatility seem to have forgotten that there are some serious macro issues in the world. As Eric Noll argued in his testimony: “Restricting or eliminating the [ETF] business will not solve the sovereign debt crisis in Europe, will not balance the US budget, will not restore bank balance sheets, will not add jobs, and will not repay consumer debt and get them spending again. There are very large, very real uncertainties that are driving global financial market volatility.”

If ETFs—leveraged or otherwise—are found to be contributing to market instability after a thorough investigation, I will be the first to support increased regulation. Until then, I’m inclined to echo the words of Dave Nadig of IndexUniverse. “There’s a big difference between being a niche, complex and sometimes misused product and being a threat to modern capitalism,” he writes. “Leveraged and inverse funds aren’t for everyone. In fact, they’re not for most people. They’re expensive, complex and require constant monitoring if held for more than a day…. But these funds aren’t the progenitors of some sort of global collapse.”