Influence of Leveraged ETFs

from the Daily Options Report blog:

Now I know many prefer the notion that a cabal of a few Big Evil Hedge Funds control the close each day. But perhaps it's something even more sinister, Big Evil Leveraged ETF's? Or rather, the rebalancing of swaps thereof. This, from the Journal (hat tip Don Fishback and Abnormal Returns).

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.

........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.

I had heard this was a factor in why moves often snowball late in a day. But what I hadn't heard, but should have just known, was something like this.

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.

So while it's "comforting" to know these funds aren't causing the melt downs or melt ups, good to know they're still using a stacked deck to profiteer off it.

As always with these sort of shenanigans, you'll go broke waiting for the SEC to reign it in. The best tack is to know it's part of the backdrop, and trade accordingly. If it walks like a trend day and talks like a trend day, it's probably a trend day. Which means you likely get a low and last, or high and last, sort of close. And in a world of popular Leveraged ETF's, and hedge funds getting The Look, it's probable that move will get exascerbated. So it pays to just trade accordingly.