It’s getting crazy out there in ETF land. Leveraged exchange traded funds like Direxion Funds that deliver two times the return of a benchmark are being jacked up to three times the return. Many market observers believe that the highly leveraged exchange traded funds are contributing to the market volatility that is causing investors to flee the stock market. (“Beware of ETFs On Steroids,” Bloomberg Business Week, Markets & Finance).
Laurence D. Fink, chief executive officer of BlackRock Inc., the world’s largest ETF provider and one of the world’s largest money managers, said: “I do believe we have some responsibility for making sure that the market does not morph itself, the same way when I started in the mortgage market 35 years ago, watching a great market morph into a monster.”
Leveraged exchange traded funds use derivatives (options and futures) to produce the outsized leverage. They are also known as synthetic exchange traded funds. The risks, of course, are that leverage amplifies losses as well as gains, and introduces significant tracking errors. Holding a leveraged exchange traded fund for more than a short period can result in losses when the underlying benchmark generates a gain, and vice versa.
Exchange traded funds comprise 35 to 40 percent of U.S. exchange trading, according to Morningstar. Leveraged exchange traded funds make up only 3 percent of ETF assets, but account for 14 percent of total ETF trading.
They are warping the stock market. Harold S. Bradley, manager of the $1.7 billion Ewing Marion Kauffman Foundation endowment, said: “Leveraged ETFs aren’t tracking stocks as much as they are creating stock prices. That undermines investor confidence.”
Exchange traded funds are also of concern to global regulators, who are expected to increase disclosure requirements and issue warning to retail investors. This “will force sponsors to conduct more due diligence on the appropriateness of their products for certain investors’.” (“How Should Regulators Handle Exchange Traded Funds,” Institutional Investor).
Regulation is moving at a slower pace in the U.S., where synthetic exchange traded funds are reportedly not as common as in Europe. The U.S. Senate held hearings in October, but they focused more on the market effects than their unsuitability as investments. The Securities and Exchange Commission is reportedly still investigating exchange traded funds.
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